Module 2 AFM Cash Management

8/8/2019 Module 2 AFM Cash Management

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Cash management


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Introduction

Cash management is one of the key areas of workingcapital management.

Apart from the fact that it is the most liquid current asset,cash is the common denominator to which all currentassets can be reduced because the other major liquidasset, that is, receivables and inventory get eventuallyconverted into cash.

This underlines the significance of cash management.

Cash is the ready currency to which all liquid assets canbe reduced.

Near cash implies marketable securities viewed the wayas cash because of their high liquidity.


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Motives for holding cash

Transaction motive

Precautionary motives

Speculative motives Compensating motives


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Transaction motive

An important reason for maintaining cash balances is thetransaction motive.

This refers to holding of cash to meet routine cashrequirements to finance the transaction which a firm

carries on in the ordinary course of business. For example, cash payment have to be made for

purchases, wages, operating expenses, financialcharges like interest, taxes, dividends and so on.

If the receipt of cash and its disbursements could exactly

coincide in the normal course of operations, a firm wouldnot need cash for transaction purposes.


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Precautionary motives

In addition to the non-synchronization of anticipated cashinflows and outflows in the ordinary course of business,a firm may have to pay cash for purpose which cannotbe predicted or anticipated.

The unexpected cash need at short notice may be the

result of: Floods, strike and failure of important customers; Bills may be presented for settlement earlier than

expected. Unexpected slow down in collection of accounts

receivable Cancellation of some orders for good as the customer is

not satisfied And sharp increase in cost of raw materials


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Contd

The cash balance held in reserve for such random and

unforeseen fluctuations in cash flow are called

precautionary balances.

Thus precautionary cash balance serves to provide acushion to meet unexpected contingencies.

Such cash balance are usually held in the form of

marketable securities so that they earn a return.


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Speculative motives

It refers to the desire of a firm to take advantage of

opportunities which presents themselves at unexpected

moments and which are typically outside the normal

course of business. The speculative motive represents a positive and

aggressive approach

Firms aim to exploit profitable opportunities and keep

cash in reserve to do so.


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Contd

The speculative motive helps to take advantage of :

An opportunity to purchase raw materials at a reduced

price on payment of immediate cash

A chance to speculate on interest rate movements bybuying securities when interest rates are expected to

decline.

Delay purchases of raw materials on the anticipation of

decline in prices Make purchases at favorable prices


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Compensating motives

y Yet another motive to hold cash balances is to compensatebanks for providing certain services and loans.

y Banks provide a variety of services to business firms, such asclearance of cheque, supply of credit information, transfer of

funds, and so on.y While for some of these services bank charges a commission

or fees, for other they seek indirect compensation.

y Usually clients are required to maintain a minimum balance ofcash at the bank.

y Since this balance cannot be utilized by the firms fortransaction purposes, the banks themselves can use theamount to earn a return. Such balances are compensatingbalances


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Contd

The compensating cash balances can take eitherof two forms

(i) an absolute minimum, say, Rs 5 lakhs below

which the actual bank balance will never fall (ii) a minimum average balance, say, Rs 5 lakh

over the month

Of the four primary motives of holding cashbalances the two most important are thetransaction motives and compensation motives.


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Objectives of cash

management Meeting payment schedules

Minimizing funds committed to cash

balance.


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Factors determining cash

needsySynchronization of cash flows

yShort costs

y (i) transaction costs

y (ii) borrowing costs

y (iii) loss of cash-discount

y (iv) cost associated with deterioration of

the credit ratingy (v) penalty rates

yExcess cash balance cost

yProcurement and management


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Baumol model

The Baumol model of cash management provides aformal approach for determining a firms optimum cashbalance under certainty.

It considers cash management similar to an inventory

management problem.

The purpose of this model is to determine the minimumcost amount of cash that a financial manager can obtainby converting securities to cash, considering the cost ofconversion and counter-balancing cost of keeping idlecash balances which otherwise could have beeninvested in marketable securities


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Contd

The total cost associated with cash management,

according to this model has two elements:

(i) cost of converting marketable securities into cash and

(ii) the lost opportunity cost. The baumols model makes the following

assumptions:

The firm is able to forecast its cash needs with certainty.

The firms cash payments occur uniformly over a periodof time.

The opportunity cost of holding cash is known and it

does not change over time.

The firm will incur same transaction cost whenever itconverts securities to cash.


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Contd

Let us assume that the firm sells securities and startswith a cash balance of C rupees. As the firm spendscash, its cash balance decreases steadily and reachesto zero. The firm replenishes its cash balance to C

rupees by selling marketable securities. This pattern continues over time. Since the cash balance

decreases steadily the average cash balance will be :

C/2.

This pattern is shown below


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Contd

Cash balance

Time

Average

C

C/2

T1 T2 T30


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Contd

The firm incurs a holding cost for keeping the

cash balance. It is an opportunity cost; that is the

return foregone on the marketable securities. If

the opportunity cost is i, then the firms holdingcost for maintaining an average cash balance is

as follows:

Holding cost or opportunity cost = i(C/2)

Where i= interest rate that could have been

earned

C/2= the average cash balance that is, the

beginning cash (C) plus the ending cash


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Contd

The firm incurs a transaction cost whenever itconverts its marketable securities to cash. Totalnumber of transactions during the year will be

total funds requirements, T, divided by the cashbalance, C, i.e. T/C. the per transaction cost isassumed to be constant. If per transaction costis b then total transaction cost will be:

transaction cost or total conversion cost perperiod = b(T/C)

Where b= cost per conversion

T= total transaction cash needs for the period

C= value of marketable securities sold at each


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Contd

The total annual cost of demand for cash will

comprise of total conversion cost plus

opportunity cost symbolically it can be

expressed as i (C/2) +(b)(T/C)


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Contd

To minimize the cost, therefore, the model

attempts to determine the conversion amount

that is the cash withdrawal which costs the least.

The optimum cash balance is obtained when thetotal cost is minimum

C= 2bt

i


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Contd

Cash BalanceCash Balance

AnnualAnnualcostcost

Slope = 0Slope = 0

MinimumMinimumtotal costtotal cost

Total CostTotal Cost

Transaction Cost =Transaction Cost =TbTb

CC

Opportunity Cost =Opportunity Cost =iCiC

22


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Miller-Orr model

The limitation of boumol model is that it

dose not allow the cash flow to fluctuate.

Firm in practice do not use their cash

balance uniformly nor they are able to

predict daily cash inflows and outflows.

The miller Orr model overcomes this

shortcomings and allows for daily cashflow variation .

Miller Orr assumes that the changes in

cash balance over a given period are


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Time

The Miller - Orr Model

Lower Limit

Upper Limit

Z orReturn poin

Sell Securities

Buy SecuritiesUL

LL


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Contd

If the firms cash flows fluctuate randomly

and hit the upper limit, then it buys

sufficient marketable securities to come

back to the normal level of cash(the return

point ) similarly when the firms cash flow

wander and hit the lower limit it sells

sufficient marketable securities to bring thecash level back to the normal level.


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Contd

While the value of lower control limit (LL)

is set by the management based on what

it considers to be the minimum below

which the cash balance should not fall, the

values of RP and UL have been derived by

miller Orr with the view to minimizing the

total ordering and holding costs. The following are the results of the

analysis

RP =3 3b(s.d)2 + LL


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Control of cash collection and

disbursement.

The strategic aspect of efficient cash

management approach are:

speedy collection of accounts receivablesand

delaying the payments on accounts

payable.

Speedy cash collections: in managing

cash efficiently, the cash inflow process

can be accelerated through systematic

planning and refined techniques. There


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Prompt payment by

customer One way to ensure prompt payment bycustomer isprompt billing. What the

customer has to pay and the period of

payment should be notified accuretly and

in advance. The use of mechanical

devices for billing along with the enclosure

of a self-addressed return envelope willspeed up payment by customers.

Another, and more important, technique to

encourage prompt payment by customers,


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Early conversion of payments

into cash.

Once the customer makes the payment by writing a cheque inthe favor of the firm, the collection can be expedited by

prompt encashment of the cheque. There is a lag between thetime a cheque is prepared and mailed by the customer and thetime the funds are included in the cash reservoir of the firm.Within the time interval three steps are involved:

A) Transit or mailing time, that is, the time taken by the postoffices to transfer the cheque from the customer to the firmreferred to as postal float.

B) Time taken in processing the cheque within the firm before

they are deposited in the banks, termed as lethargy; C) collection time within the bank, this is called bank float.


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Contd

The early conversion of payment into cash, as a

technique to speed up collection of accounts

receivable, is done to reduce the time lag

between the posting of the cheque by thecustomer and the realization of money by the

firm. The postal float lethargy and the bank float

are collectively referred to as deposit float. The

term float is defined as the sum of chequewritten by customer that are not yet useable by

the firm.


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Contd

An important cash management technique

is reduction in deposit float.

This is possible if the firm adopts he policyof decentralised collections

The principal method of establishing

decentralized collection network are

Concentration banking

Lock-box system


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Concentration banking

Concentration banking is a system of

operating through a number of collection

centers, instead of a single collection

center centralized at the firms head office.

The basic objective of decentralized

collection is to minimize the lag between

the mailing time from customer to the firmunder this system the firm will have a large

number of bank accounts operated in the

areas where the firm has its branches.


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Contd

The collection centers will be required to

collect cheques from customers and

deposit it in their local bank accounts.

The collection center will transfer funds

above some predetermined minimum to a

central or concentration bank account. A

concentration bank is one where the firmhas a major account usually disbursement

account.

Funds can be transferred to a central or


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Lock-box system

Lock-box system another technique of

speeding up the mailing, processing time

and, collection time is lock-box system.

In concentration banking cheques are

received by a collection center and after

processing are deposited in the bank.

Lock-box system helps the firm to

eliminate the time between the receipts of

cheques and their deposit in the bank.

In a lock-box system, the firm establishes


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Contd

At each center, the firm hires a post office

box and instructs its customers to mail

their remittance in the box.

The firms local bank is given the authority

to pick-up the remittance directly from the

lock box.

The bank picks up the mails several times

a day and deposits the cheques in the

firms account.

For the internal accounting purpose of the


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Contd

Two main advantages are

1. The bank handles the remittance prior to

deposit at a lower cost.2. The cheques are deposited immediately

upon receipt of remittance and their

collection processes sooner than if the

firm would have processed them for

internal accounting purpose prior to their

deposits.

Both the systems involve cost. Whether


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Delaying payments on

accounts receivable

This can be done through:

Avoidance of early payments Centralized disbursement

Float

Paying from a distant bank Accruals


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Strategies for managing

surplus cash Do nothing: the financial manager simplyallows surplus liquidity to accumulate in

the current account. This strategy

enhances liquidity at the expense of profits

that could be earned from investing

surplus fund.

Make ad hoc investments: the financialmanager makes investments in some what

ad hoc (unplanned, unprepared) manner

such a strategy makes some contribution,


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Contd

Ride the yield curve: this is a strategy to

increase the yield from a portfolio of

marketable securities by betting on

interest rate changes.

If the financial manager expects that

interest rates will fall in the near future he

would buy longer term securities as theyappreciate more, compared to short term

securities.

On the other hand, if the financial manager


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Contd

Develop guidelines: a firm may develop a

set of guidelines which may reflect the

view of the management towards risk and

return.

Examples of such guidelines are:

(i) Do not speculate on interest rate

changes. (ii) Hold marketable securities till

they mature (iii) do not put more than a

certain percentage of liquid funds in a

particular security or instrument (iv)


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Contd

Utilize control limits: there are some

models of cash management which

assumes that cash inflow and outflow

occur randomly (irregular) over time.

Based on this premise, these models

define the upper and lower control limits.

When the cash balance touches the upper

limit, the model prescribes that a certain

amount should be invested in the

marketable securities and when the cash


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Contd

Manage with a portfolio perspective: according to the

portfolio theory there are two key steps in portfolio

selection.

D

efine the efficient frontier: the efficient frontierrepresents a collection of all efficient portfolios. A

portfolio is efficient if and only if there is no alternative

with (i) the same expected return and a lower standard

deviation, or (ii) the same standard deviation and a

higher expected return, or (iii) a high expected return anda lower standard deviation

Select the optimal portfolio: the optimal portfolio is that

point on the efficient frontier which enables the investor

to achieve the highest attainable level of utility.


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Stone model

The Stone Model is somewhat similar to

the Miller-OrrModel in so far as it uses

control limits.

It incorporates, however, a look-ahead

forecast of cash flows when an upper or

lower limit is hit to take into account the

possibility that the surplus or deficit ofcash may naturally correct itself.

If the upper control limit is reached, but is

to be followed by cash outflow days that


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Contd

Of course, if cash were in short supply and the lower

control limit was reached, the opposite would apply.

In this way the Stone Model takes into consideration the

cash flow forecast.

The goals of these models are

To ensure adequate amounts of cash on hand for bill

payments,

To minimize transaction costs in acquiring cash when

deficiencies exist,

And to dispose of cash when a surplus arises.

These models assume some cash flow pattern as a

given, leaving the task of cash collection, concentration,

and disbursement to other methods.


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Long term cash

forecasting Long term cash forecast are prepared togive an idea of the companies financial

requirements in distant future. They are

not as detailed as short term forecast.

Long term cash forecast can be made for

a period of two three or five years .

Once a company has developed long term

cash forecast it can be used to evaluate

the impact of say new product

developments or plant acquisitions on the


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Contd

The major uses of long term cash forecast

are:

I

t indicates as companys future financialneeds, especially for its working capital

requirements.

It helps to evaluate proposed capital

projects. It pinpoints the cash required to

finance these projects as well as the cash

to be generated by the company to

support them.


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Short term cash forecast

It is comparatively easy to make short

term forecasts. The important functions of

carefully developed short-term cash

forecast are:

To determine operating cash requirement

To anticipate short term financing

To manage investment of surplus cash

Some more uses of these forecasts are:

Planning reduction of short and long term


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Contd

Two most commonly used methods of

short term cash forecasting are

The receipt and disbursement method The adjusted net income method


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Cash budget

Cash budget is a statement of the inflows

and outflows of cash that is used to

estimate its short term requirements.

The cash budget is probably the most

important tool in cash management it is a

device to help a firm to plan and control

the use of cash.

It is a statement showing the estimated

cash inflows and outflows over the

planning horizon

Documents

Module 2 AFM Cash Management