Cash management

1. Define cash management & Describe the objectives of cash

management

Answer: Cash is the ready currency to which all liquid assets can be reduced. Cash management
deals with the optimization of the collection and disbursement of cash. It involves assessing market
liquidity, cash flow, and investments. The objectives of cash management are given below:
1. Meeting payment schedule: In the normal course of functioning, a firm has to make various
payments by cash to its employees, suppliers and infrastructure bills. Firms will also receive
cash through sales of its products and collection of receivables. Both of these do not occur
simultaneously. The basic objective of cash management is therefore to meet the payment
schedule on time. The advantages of adequate cash are:

a) Higher Productivity and Liquidity

b) Firm can avail cash as well as trade discounts
c) It helps to improves credit worthiness and good will
d) It provides regular flows of cash
e) Firm can enjoy new business opportunities
f) It helps to overcome short term crises
g) It creates good confidence among the investors
h) It ensures timely procurement of raw material

2. Minimizing Funds Committed to Cash Balances: The second objective of cash

management is to minimize cash balances. In minimizing the cash balances, two conflicting
aspects have to be reconciled. A high level of cash balances and a low level of cash balances.
Keeping in view these conflicting aspects of cash management, we propose to discuss the
planning/determination of the need for cash balances. There are two aspects involved in cash
planning: first, an examination of those factors which have a bearing on the firm’s required
cash balances; second, a review of the approaches to achieve optimum cash balances.

2. Describe the factors determining cash needs

Answer: The factors determining cash needs are given below:

1. Synchronization of cash flows: Cash inflows and outflows should be so planned as it would
help in determining cash surplus or deficit for the period for which the plan is related. With
this object in view, the first consideration is to ascertain the discrepancies between cash
receipts and cash payments on the basis of normal business activities. For this purpose, cash
budget is to be prepared. This method shows the timing and magnitude of expected cash
collection and uses over the budgeted period.
2. Short costs: Another general factor to be considered in determining cash needs is the cost
associated with a shortfall in the cash needs. Various short costs are -

a. Transaction costs associated with rising cash to tide over the shortage.
b. Borrowing costs associated with borrowing to cover the shortage.
c. Loss of cash-discount, that is, a substantial loss because of a temporary’ shortage of cash.
d. Penalty rates by banks to meet a, shortfall in compensating balances.

3. Excess Cash Balance Costs: The cost of having excessively large cash balances is known as the excess
cash balance cost. If large funds are idle, the implication is that the firm has missed opportunities to
invest those funds and has thereby lost interest which it would otherwise have earned. This loss of
interest is primarily the excess cost.
4. Procurement and Management: These are the costs associated with establishing and
operating cash management staff and activities. They are generally fixed and are mainly
accounted for by salary, storage, handling of securities, and so on.
5. Uncertainty and Cash Management: Finally, the impact of uncertainty on cash management
strategy is also relevant as cash flows cannot be predicted with complete accuracy. It can be
mitigated through a. Improved forecasting of tax payments, capital expenditure, dividends,
and so on; and b. increased ability to borrow through overdraft facility.

3. Describe the various models of cash management / state the similarities

and differences among Baumol model, miller-or model and orgler's
cash management model

Answer: The various models of cash management are given below:

A. William Baumol Model: A model that provides for cost efficient transactional balances and
assumes that the demand for cash can be predicted with certainty and determines the optimal
conversion size / lot. The objective is to minimize the sum of the fixed costs of transactions
and the opportunity cost of holding cash balances that do not yield a return. This is similar to
the EOQ model used in inventory management. The costs can be expressed as follows,
according to his model:

𝐶 𝑇𝑏
i( )+( )
2 𝐶

Where: b = Fixed costs of a transaction

Total cash required for the specified time
T=
period
i = Interest rate on marketable securities
C = Cash balance

The optimal level of cash is determined using the following formula:

2𝑏𝑇
Optimal level of cash = √
𝑖
B. Miller-Orr Model: The objective of cash management, according to Miller-Orr (MO), is to
determine the optimum cash balance level which minimizes the cost of cash management.
Symbolically,

𝑏𝐸 (𝑁)
C= +iE (M)
𝑡

Where

b = the fixed cost per conversion,

E (M) = the expected average daily cash balance,
E (N) = the expected number of conversions,
t = the number of days in the period,
i = the lost opportunity costs, and
C = total cash management costs

The MO Model assumes that cash balances randomly fluctuate between an upper bound (b) and a
lower bound (o). When the cash balances hit the upper bound, the firm has too much cash and
should buy enough marketable securities to bring the cash balances back to the optimal bound (z).
When the cash balances hit zero, the financial manager must return them to the optimum bound
(z) by selling/convening securities into cash. According to the MO Model, the optimal cash balance
(z) can be expressed symbolically as

3 3br2
z= √
4i

Where, r 2 = the variance of the daily changes in cash balances.

The MO Model also specifies the optimum upper boundary (b) as three times the optimal cash
balance level such that b=3z.

C. Orgler's Model: According to this model, the optimal cash management strategy can be
determined through the use of a multiple linear programming model. It is a model that provides
for integration of cash management with production and other aspects of the firm. The
construction of this model comprises three sections namely:

a. Selection of the appropriate planning horizon

b. Selection of the appropriate decision variables and
c. Formulation of the cash management strategy.

This model uses one year planning horizon with twelve monthly periods because of its simplicity.
It has four basic sets of decision variables which influence cash management of a firm and which
must be incorporated into the linear programming model of the firm. These are
 a. Payment schedule
b. Short-term financing and
c. Purchase and sale of marketable securities and
d. Cash balance.

The familiarity of all the above models provides the financial managers an insight into the
normative framework as to how cash management should be conducted.

4. What do you mean by Cash budget? & what are the purposes of cash
budget?

Answer: A cash budget is a detailed plan showing how cash resources will be acquired and used
over a specific time period. It states all the cash inflows and outflows for a certain period of time.
It is also known as financial budget. It generally includes cash collections from customers, cash
disbursement for purchases and operating expenses, Capital expenditure, loans and loan payment.
The various purposes of cash budgets are:
1. To coordinate the timings of cash needs. It identifies the period(s) when there might either
be a shortage of cash or an abnormally large cash requirement;
2. It pinpoints the period(s) when there is likely o be excess cash;
3. It enables a firm which has sufficient cash to take advantage of cash discounts on its
accounts payable, to pay obligations when due, to formulate dividend policy, to plan
financing of capital expansion and to help unify the production schedule during the year so
that the firm can smooth out costly seasonal fluctuations; finally,
4. It helps to arrange needed funds on the most favorable terms and prevents the accumulation
of excess funds. With adequate time to study his needs, the finance manager can select the
best alternative.

5. Describe the Elements/Preparation of Cash Budget

Answer: The preparation of a cash budget involves various steps. These may be described as the
elements of the cash budgeting system.

The first element of a cash budget is the selection of the period of time to be covered by
the budget. It is referred to as the planning horizon. The planning horizon means the time span and
the sub-periods within that time span over which the cash flows are to be projected. There is no
fixed rule. The coverage of a cash budget will differ from firm to firm depending upon its nature
and the degree of accuracy with which the estimates can be made. As a general rule, the period
selected should be neither too long nor too short. If it is too long, it is likely that the estimates will
be inaccurate. If, on the other hand, the time span is too small, many important events which lie
just beyond the period cannot be accounted for and the work associated with the preparation of the
budget becomes excessive. The planning horizon of a cash budget should be determined in the
light of the circumstances and requirements of a particular case.
 The second element of the cash budget is the selection of the factors that have a bearing on
cash flows. Cash flows are of following two types -
A. Operating cash flow: Operating cash flows are cash flows generated by the operations of
the firm. Operating cash flow items are given below:

Inflow/Cash Receipts Outflows / disbursement

1. Cash sales 1. Accounts payable/Payable payments
2. Collection of accounts receivable 2. Purchase of raw materials
3. Disposal of fixed assets 3. Wages and salary (payroll)
4. Factory expenses
5. Administrative and selling expenses
6. Maintenance expenses
7. Purchase of fixed assets

B. Financial cash flows: Financial cash flows are cash flows generated by the financial
activities of the firm. Items for financial cash flows are given below:

Cash inflows/Receipts Cash Outflows/ payments

1. Loan & Borrowings 1. Income-tax / Tax payments
2. Sales of securities 2. Redemption of loan
3. Interest received 3. Repurchase of shares
4. Dividend received 4. Interest paid
5. Rent received 5. Dividends paid
6. Refund of tax
7. Issue of new shares and securities

6. What are the basic strategies of efficient cash management? Illustrate

with suitable examples the effect of these on the operating cash
requirement of a firm.
Answer: The basic strategies of efficient cash management are given below:
1. Stretching Accounts Payable: The firm should pay its accounts payable as late as possible
without damaging its credit standing. This is one of the main strategies of efficient cash
management. But the firm should take advantage of cash discount, if any, offered by suppliers
for prompt payment. The reason is that, the cost of not taking a discount will work out more
than the cost of delaying payment.
2. Efficient Inventory-Production Management: Another strategy is to increase the inventory
turnover, avoiding stock-outs or shortage of stocks, by the following ways:
a. Increasing the raw materials turnover by using more efficient inventory control
techniques.
b. Decreasing the production cycle through better production planning, scheduling and
control techniques, which will lead to an increase in the work-in-progress inventory
turnover.
c. Increasing the finished goods turnover through better forecasting of demand and a better
planning of production.
3. Speeding Collection of Accounts Receivable: By effective collection efforts and by speeding
up the collection of accounts receivables, the cash cycle would come down, thereby resulting
in saving a cost to the firm. But the speeding up of accounts receivables should be done very
carefully so that the customers are not lost. The average collection period of receivables can
be reduced by changes in credit terms, credit standards and collection policies. Cash discounts
should be given for immediate payments.
4. Combined cash management strategies: Each one of the above cash management strategies
has a favorable effect on the operating cash requirement. If all of the above strategies are
combined effectively, it will lead to the most efficient cash management system.
Example:
Let us assume that a firm currently takes 40 days to pay its suppliers, allows 75 days to collect
receivables and a gap of 90 days between purchase of raw materials and the sale of finished
goods.
Total operating annual outlay = $250,000.
∴ Current cash cycle = 90 days + 75 days - 40 days = 125 days
∴ cash turnover = 365/125 = 2.92 or 3 days.
∴ Minimum operating cash = $250,000/2.92 days = $85,616.44

Now,
Let us assume that the firm applies all the above cash management strategies, as a result of which
Accounts payable increases by 15 days
Average age of inventory reduces by 20 days
Speeds up collection by 25 days.
The new cash cycle would be => (90-20) + (75-25) - (40+15)
=> 70 + 50 - 55 => 65 days

∴ the new cash turnover would be = 365/65 = 5.6 days

∴ The new minimum operating cash requirement = $250,000/5.6 days = $44,642.86 or $44,643.
Difference in minimum operating cash requirement => $85,616 (old) - $44,643 (new) = $40,973.
If a 10% of interest is applicable, the savings in interest cost would be $40,973 x 10% =
$4,097.30. This is the result of efficient cash management.
7. What specific strategies can be adapted to slow disbursement of account
payable?

Answer: The operating cash requirement can be reduced by slow disbursements of accounts
payable. It represents a source of funds requiring no interest payments. The techniques to delay
the payments of accounts payable are:
1. Avoidance of early payments: One way to delay payments is to avoid early payments.
The firm should pay its payable only on the last day of the payment. If the firm avoids early
payment of cash, the firm can retain the cash with it and that can be used for other purpose.
2. Centralized disbursements: Another method to slow down disbursement is to have
centralized disbursement. The head office should make all the payments from a centralized
disbursement account. Such an arrangement would enable a firm to delay payments and
conserve cash for several reasons. Firstly, it involves increase in transit time. Secondly, the
reason for reduction in operating cash requirement is that since the firm has a centralized
bank account, a relatively smaller total cash balance will be needed.
3. Float: A very important technique of slow disbursement is float. The term float refers to
the amount of money tied up in cheques that have been written, but have yet to be collected
and encased. Alternatively, float represents the difference between the bank balance and
bank balance of cash of a firm. The difference between the as shown by the concern record
and the actual bank balance is due to transit and processing delays. There are three ways
of float are as below: (a) Paying from a distant bank. (b) Cheque-encashment analysis and,
(c) Bank draft.
4. Accruals: Another important tool for delaying the accounts payable is accruals which are
defined as current liabilities that represent a service or goods received by a firm but not yet
paid for.

8. Describe the selection criteria for marketable securities

Answer: The selection criteria for marketable securities include the evaluation of –
a. Financial/Default Risk: Financial risk is the uncertainty of expected return attributable to
possible change in financial capacity of issuer of security to make future payments. If the
chance of default on the terms of the investment is high (low), then the financial risk is said
to be high (low).
b. Interest Rate Risk: Interest rate risk is the uncertainty that is associated with the expected
returns from a financial instrument attributable to changes in interest rate. If prevailing
interest rates rise compared with the date of purchase, the market price of the securities
will fall to bring their yield to maturity in line with what financial managers could obtain
by buying a new issue of a given instrument. To hedge against the price volatility caused
by interest rate risk, the market securities portfolio will tend to be composed of instruments
that mature over short periods.
c. Taxability Another factor affecting observed difference in market yields is the differential
impact of taxes. Securities, income on which is tax-exempt, sell in the market at lower
yields to maturity than other securities of the same maturity. A differential impact on yields
arises also because interest income is taxed at the ordinary tax rate while capital gains are
taxed at a lower rate.
 d. Liquidity: With reference to marketable securities portfolio, liquidity refers to the ability
to transform a security into cash. In the formulation of preferences for the inclusion of
particular instruments in the portfolio, consideration will be given to (1) the time period
needed to sell the security and (ii) the likelihood that the security can be sold at or near its
prevailing market price.
e. Yield: The final selection criterion is the yields that are available on the different financial
assets suitable for inclusion in the marketable/near-cash portfolio. All the four factors listed
above influence the available yields on financial instruments. Therefore, the yield criterion
involves a weighing of the risks and benefits inherent in these factors.

Definition
b = Fixed costs of a transaction
T = Total cash required for the specified time
period
i = Interest rate on marketable securities
C = Cash balance

E (M) = the expected average daily cash i = the lost opportunity costs, and
balance, Z= The optimal cash balance
E (N) = the expected number of r 2 = the variance of the daily changes in cash
conversions, balances.
t = the number of days in the period,

Formula
𝐶 𝑇𝑏
Total Costs under Baumol Model = i ( )+( )
2 𝐶

𝑇𝑏
1. Total conversion cost per period =
𝐶
2𝑏𝑇
2. Optimal level of cash = √
𝑖
𝑏𝐸 (𝑁)
3. C = +iE (M)
𝑡
3 3br2
4. z= √
4i
5. The optimum upper boundary (b) as three times the optimal cash balance level such that
b=3z.
6. Cash cycle = Average age of Inventory + Average collection period - Average Accounts
Payable period
7. Cash turnover = Number of times cash is used during the year = Number of days in a
year/Cash cycle.
 Working Capital Financing

1. What are the features and advantages of trade credit as a short term
source of working capital finance? How can the cost of trade credit be
calculated?

Answer: Trade credit refers to the credit extended by the supplier of goods and services in
the normal course of transaction /business/ sale of the firm. The features of trade credit are
given below:
1. There are no formal legal instruments/acknowledgements of debt.
2. It is an internal arrangement between the buyer and seller.
3. It is a spontaneous source of financing.
4. It is an expensive source of finance, if payment is not made within the discount period.

Advantages:
1. It is easy and automatic source of short-term finance.
2. It reduces the capital requirement.
3. It helps the business focus on core activities.
4. It does not require any negotiation or formal agreement.

Cost calculation under trade credit:

Trade credit does not involve any explicit interest charge. However, there is an implicit cost of
trade credit. It depends on the credit terms offered by the supplier of goods. If the terms of the
credit are, say, 45 days net, the payable amount to the supplier of goods is the same whether paid
on the date of purchase or on the 45th day and, therefore, trade credit has no cost, that is, it is cost-
free. But if the credit terms are, say, 2/15, net 45, that is, there is discount for prompt payment; the
trade credit period beyond the discount period has a cost called implicit interest cost.

Here,
𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 360 𝑑𝑎𝑦𝑠
Implicit interest rate/cost = ( )( )
1−𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝐶𝑟𝑒𝑑𝑖𝑡 𝑝𝑒𝑟𝑖𝑜𝑑𝑠−𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑝𝑒𝑟𝑖𝑜𝑑𝑠

.02 360 𝑑𝑎𝑦𝑠

=( )( )
1−.02 45 𝑑𝑎𝑦𝑠−15 𝑑𝑎𝑦𝑠

= 24.5%

Similarly, if the terms of credit are 2/10, net 30, the cost of credit works out to 36.4 per cent.
The longer the difference between the payment day and the end of the discount period, the larger
is the annual interest/cost of trade credit.
2. Discus the main forms of working capital advance by banks.
Answer: The main forms of working capital advance by banks are given below:
1. Cash credit: A cash credit is an arrangement by which a bank allows his customer to
borrow money up to certain limit against the security of the commodity.
2. Overdrafts: Overdraft is an arrangement with a bank by which a current account holder is
allowed to withdraw more than the balance to his credit up to a certain limit without any
securities.
3. Loans: Under this arrangement, the entire amount of borrowing is credited to the current
account of the borrower or released in cash. The borrower has to pay interest on the total
amount. The loans are repayable on demand or in periodic installments. They can also be
renewed from time to time.
4. Bill purchase / discount: Under this type of lending, Bank takes the bill drawn by
borrower on his (borrower's) customer and pays him immediately deducting some amount
as discount/commission. The Bank then presents the Bill to the borrower's customer on the
due date of the Bill and collects the total amount.
5. Term Loans for Working Capital: Under this arrangement, banks advance loans for 3-7
years repayable in yearly or half-yearly installments.
6. Letter of Credit: While the other forms of bank credit are direct forms of financing in
which banks provide funds as well as bear risk, letter of credit is an indirect form of
working capital financing and banks assume only the risk, the credit being provided by the
supplier himself.

3. Describe the modes of security in case of providing bank credit

Answer: Bank provides credit on the basis of the following modes of security:
1. Hypothecation: Under this mode of security, the banks provide credit to borrowers against
the security of movable property, usually inventory of goods. The goods hypothecated,
however, continue to be in the possession of the owner of these goods (i.e., the borrower). The
rights of the lending bank depend upon the terms of the contract between the borrower and the
lender.
2. Pledge: Under this mode of security, the banks provide credit to borrowers against the security
of movable property, usually inventory of goods and the goods which are offered as security
are transferred to the physical possession of the lender.
3. Lien: The term 'lien' refers to the right of a party to retain goods belonging to another party
until a debt due to him is paid. Lien can be of two types (a) Particular lien is a right to retain
goods until a claim pertaining to these goods is fully paid and (b) general lien can be applied
till all dues of the claimant are paid. Banks usually enjoy general lien.
4. Mortgage: Mortgage is the additional security of immoveable property to obtain short-term
loan. The person who parts with the interest in the property is called 'mortgagor' and the bank
in whose favor the transfer takes place is the 'mortgagee'. The instrument of transfer is called
the 'mortgage deed'.
5. Charge: Where immovable property of one person is, by the act of parties or by the operation
of law, made security for the payment of money to another and the transaction does not amount
to mortgage, the latter person is said to have a charge on the property and all the provisions of
simple mortgage will apply to such a charge.
4. State the differences between Charge and mortgage

Answer: The differences between chare and mortgager are given below:
1) A charge is not the transfer of interest in the property though it is security for payment. But
mortgage is a transfer of interest in the property.
2) A charge may be created by the act of parties or by the operation of law. But a mortgage
can be created only by the act of parties. ·
3) A charge need not be made in writing but a mortgage deed must be attested.
4) A charge cannot be enforced against the transferee for consideration without notice. In
mortgage, the transferee of the mortgaged property can acquire the remaining interest in
the property, if any is left.

5. Discuss briefly commercial papers as source of working capital finance.

How would you compute the cost of commercial papers?

Answer: Commercial paper can be defined as a short term, unsecured promissory notes which are
issued at discount to face value by well-known companies that are financially strong and enjoy a
high credit rating. The features of commercial paper are given below:

1. They are negotiable by endorsement and delivery and hence they are flexible as well as liquid
instruments.
2. They are unsecured instruments as they are not backed by any assets of the company which
is issuing the commercial paper.
3. They can be sold directly by the issuing company to the investors.

Advantages:
1. It is quick and cost effective way of raising working capital.
2. Best way to the company to take the advantage of short term interest fluctuations in the
market.
3. They are cheaper than a bank loan.
4. As commercial papers are required to be rated, good rating reduces the cost of capital for the
company.
5. It is unsecured and thus does not create any liens on assets of the company.
6. It has a wide range of maturity.
Cost calculation of commercial paper:

As the CPs are issued at discount and redeemed at it face value, their effective pre-tax cost/interest
yield
𝐹𝑎𝑐𝑒 𝑣𝑎𝑙𝑢𝑠𝑒−𝑁𝑒𝑡 𝑎𝑚𝑜𝑢𝑛𝑡 𝑟𝑒𝑎𝑙𝑖𝑠𝑒𝑑 360 𝑑𝑎𝑦𝑠
=( )×( )
𝑁𝑒𝑡 𝑎𝑚𝑜𝑢𝑛𝑡 𝑟𝑒𝑎𝑙𝑖𝑠𝑒𝑑 𝑀𝑎𝑡𝑢𝑟𝑖𝑡𝑦 𝑝𝑒𝑟𝑖𝑜𝑑𝑠

Where,
Net amount realized = Face value – discount - issuing and paying agent (IPA) charges,
that is, stamp duty, rating charges, dealing bank fee and fee for standby facility. ·

Assuming face value of a CP, Rs 5, 00,000 maturity period, 90 days, net amount realized
/discount, Rs 4,80,000 and other charges associated with the issue of CP, 1.5 per cent, the
pre-tax effective cost of CP
Rs 5,00,000−(Rs 4,80,000−Rs 7,500) 360 𝑑𝑎𝑦𝑠
= ×( )
(Rs 4,80,000−Rs 7,500) 90 𝑑𝑎𝑦𝑠
= 23.3%
6. What is factoring? Give a brief account of the major functions of a
factor
Answer: Factoring can be defined as an agreement in which receivables arising out of sale of
goods/services are sold by a firm (client) to the 'factor' (a financial intermediary) as a result of
which the title of the goods/services represented by the said receivables passes on to the factor.
Functions of a factor: Factor is a financial institution that specializes in purchasing accounts
receivables from business firms: The functions of a factor are given below:

1. Financing trade debts: The main function of a factor is the purchase of accounts
receivables from his client at a price. The receivables then are assigned to the factor and he
grants advances based on the receivables.
2. Maintenance of sales ledger: The factor maintains the clients' sales ledgers. On
transacting a sales deal, an invoice is sent by the client to the customer and a copy of the
same is sent to the factor. The ledger is generally maintained under the open-item method
in which each receipt is matched against the specific invoice.
3. Providing collection facility: The collection problems of the customers are solved due to
the existence of the factor. The factor undertakes the collection responsibility and employs
his manpower and time to collect the receivables payment. Thus he saves the valuable time
of his customer who can concentrate more on his main work of sales.
4. Assumption of credit risk: One of the important functions of a factor is the assumption
of credit risk, especially when the receivables are factored without recourse. The factor
fixes the credit limit for the approved customers in consultation with his clients. He
undertakes to purchase all the receivables of those customers within this fixed limit and he
assumes the risk of default in payment by the customer.
5. Providing Advisory Services: These services are a spin-off of the close relationship
between a factor and a client. By virtue of their specialized knowledge and experience
in finance arid credit dealings and access to extensive credit information, factors can
provide a variety of incidental advisory services to their clients.