What is cash management?

Cash management is a broad term that covers a number of functions that help
individuals and businesses process receipts and payments in an organized and
efficient manner. Administering cash assets today often makes use of a number
of automated support services offered by banks and other financial institutions.
The range of cash management services range from simple checkbook
balancing to investing cash in bonds and other types of securities to automated
software that allows easy cash collection.

Motives for holding cash

(a) Transaction Motive: This motive refers to the holding of cash in order to
meet the day-to-day expenses of the business. These transactions including
purchase of raw material, packing materials, wages, operating expenses, taxes,
dividend etc. (1) since the timing of cash inflows and the cash outflows differ
significantly, a minimum cash balance is required. At the same time, there is
regular inflow of cash from sales proceeds, income from investments etc. But
inflows and outflows-of cash do not perfectly coincide. (2) Sometimes the firm
has surplus cash in certain periods, which the firm invests in easily marketable
securities. These are sold and cash realized when need for payment arises in
business. (3) Some firms keep cash on hand to meet some anticipated payments.
It may invest such surplus cash in such a way that it will mature when
anticipated payment is to be made. (4) The company is also required to keep
some cash on hand to make regular annual payments, e.g. once in a year, cash is
needed to pay dividend. Similarly, advance tax is payable every three months
for which a firm is required to hold some cash. Here again it can be invested in
short term marketable securities.

(b) Precautionary Motive: This motive for holding cash refers to maintaining a
cash balance to meet unexpected contingencies, which may arise as a result of

-Uncontrollable circumstances, such as floods, strikes, earthquakes etc.

- Sharp increase in the cost of materials, labor etc.

- Unexpected delay in collection of accounts receivables.

Thus precautionary balance is required to meet unforeseen contingencies. If the

event for which cash balance is kept is more unpredictable, the larger would be
the cash needed. If there has been a careful planning, less cash would be
required.
If the firm has a good prestige in the market, it can borrow from banks or from
other sources at a short notice, it will require less cash to be maintained for
contingencies. Insurance against some of the risks ma\ also come to the help, in
the sense that money can be recovered from insurance company and so less cash
may be maintained. But no cut and dried formula can be suggested. Conditions
would differ from industry to industry and also from firm to firm. It is for the
finance manager to determine the cash to be held looking to the circumstances
available. Generally such cash is held in the form of marketable securities, so
that it can earn some return.

(c) Speculative Motive: It refers to the desire of a firm to keep cash to take
advantage of profitable opportunities, which are outside the normal course of
business. It helps to take advantage of

- Purchasing raw materials at reduced prices by availing the benefits of cash

discount.

- Speculating on interest rate movements etc.

The holding of cash for speculative motive by a business firm is debatable. It is

believed that business firms should not indulge in speculative transactions, as it
involves risks that can put firm in trouble. Another viewpoint is that surplus
cash, if any, should also be invested in sound securities, so that it earns some
return. Such transactions made at times will raise the profitability of business.
However, it requires caution, foresight and skill. Hence, the best way is not to
hold cash for speculative motive.

(d) Compensating Motive: Banks provide different types of services to the

firms, e.g. clearance of cheque, transfer of funds etc. against a nominal fee or
commission. Generally, clients (firms) are required to maintain a minimum cash
balance at the bank which cannot be utilized by them for transaction purpose.
The bank can use the same for generating returns. To get compensated for free
services, they provide to customers, the banks require the clients to always keep
a bank balance sufficient to earn a return equal to the cost of services. Such
balances are called compensating balance.

The amount of cash to be held for the first two motives, which are two most
important motives, the following factors must be taken into account:

(1) The expected cash inflows and outflows based on cash budget.

(2) The degree of deviation between expected and actual net cash flows.

(3) The maturity structure of the firm’s liabilities.

(4) The firm’s ability to borrow at short notice in the event of any emergency.

(5) The philosophy of management regarding liquidity and risk of insolvency.

(6) The efficient planning and control of cash.

Objectives of cash management

1) To make Payment According to Payment Schedule:- Firm needs cash to

meet its routine expenses including wages, salary, taxes etc.

Following are main advantages of adequate cash-

1.To prevent firm from being insolvent.

2.The relation of firm with bank does not deteriorat

3.Contingencies can be met easily.

4.It helps firm to maintain good relation’s with suppliers.

(2) To minimise Cash Balance:-

The second objective of cash management is to minimise cash balance.

Excessive amount of cash balance helps in quicker payments, but excessive
cash may remain unused & reduces profitability of business. Contrarily, when
cash available with firm is less, firm is unable to pay its liabilities in time.
Therefore optimum level of cash should be maintain.

Factors determining cash needs:

(i) Synchronization of Cash flow: The need for maintaining cash balance
arises from a mis-match of cash receipts and cash payments. Hence, the first
factor taken into account is the non-synchronization of cash receipts and cash
payments. Cash budget is an appropriate technique to determine when the firm
will have excess cash or a shortage of cash.

(ii) Cash Out cost: Every shortfall in cash whether expected or unexpected is
associated with some cost, depending upon the severity, duration and frequency
of shortfall and here the shortage is covered. Expenses incurred as a result of
shortfall are called short costs. They are as follows:

(a) Cost of raising cash-Cost incurred (brokerage etc.) in selling of marketable

securities or interest expense incurred for borrowing cash.
(b) Loss of benefit of purchasing on ‘cash-discount’ terms.

(c) Loss of reputation for not being able to make payment in due time.

(iii) Idle-cash carrying cost: If the cash remains idle in the firm, the firm is
incurring an opportunity cost in terms of loss of interest had this money been
utilized somewhere else to earn some return. This loss of interest is the idle cash
carrying cost.

(iv) Cost of Cash Management: These are administrative cost incurred for
management of cash. It includes cost, salary of the concerned staff, handling
cost of securities etc.

(v) Uncertainty in Cash flows: The cost incurred is keeping idle cash to take
care of irregular cash collections, customer’s default etc. This can be reduced
through improved forecasting of cash payments and through ability to borrow
through bank overdraft.

CASH BUDGETING

Meaning-Cash budget is a schedule to record cash inflows and outflows over a

period with a view to locating the timing and magnitude of cash surplus and
shortage.

Definition-Cash budget is an estimate of cash receipts and disbursement for a

future period of time.

Importance of Cash Budget

 Cash is the nucleus or life blood in the working capital management.

 Cash budget is a useful tool in the cash management of organizations as it

reveals potential cash shortages as well as potential periods of excess
cash.

 It brings equilibrium between available cash and the cash demanding

activities – operations, capital expenditures,etc.

Advantages of Cash Budget

 It ensures that sufficient cash is available when required.

 It reveals the expected shortages of cash, so that action may be taken in

time,e.g.,a bank overdraft or loan may be arranged.
  It shows whether capital expenditure projects can be financed
internally;or arrangement has to be made borrowings.

 It reveals the availability of cash so that advantage may be taken of cash

discounts.

Methods of Cash Budget:

There are three methods usually used in preparation of cash budget:

1. Receipts and payments Method.

2. Adjusted Profit and Loss Method.

3. Projected Balance Sheet Method.

(1) Receipts and Payments Method-The estimates under this method

may be divided into weekly, fortnightly or monthly basis. The method is
of particular importance in business where sale is unstable or seasonal or
which suffers from shortage of liquid resources. Due to its flexibility,
this method is used in planning cash at various time periods and thus
helps in controlling cash disbursements.
(a) Estimating Cash Receipts: The sources of cash receipts and a
business are generally sales, non-operating incomes like interest and
dividend as well as capital transactions like sale of assets and issue of
shares and debentures. The first step in preparing a cash budget under
this method is to estimate the sales; as sale is the most important source
of cash receipts. Once the total sales are estimated, it is easy to put down
the figures of cash sales. From the past experience, the proportion of
cash sales can be determined. Any changes likely to occur in the future
budget period are taken into account. There is no time-lag between sales
and receipts in respect of cash sales.
(b) Estimating Cash Payments: Cash payments generally consist of
payment to creditors on account of credit purchases, payments for wages,
overhead expenses, dividends, capital expenditure like purchase of
assets, repayment of loans, etc. the estimates on various accounts are
based on various operating budgets, e.g. payments to creditors are
estimated on the basis of purchase budget, for wages and factory
overhead, the basis will be production budget etc. In estimating
payments to creditors, the credit period allowed by suppliers, cash
discount etc. must be considered. The payment on account of capital
expenditure can be estimated on the basis of Capital Expenditure budget.
Overheads can also be based on overheads budget. Of course,
adjustments like depreciation and accruals should not be taken into
 account. Payment on account of dividend may be a difficult problem.
But in case of companies which adopt stable dividend policy, it is easy to
estimate the total amount of dividend payable.

2) Adjusted Profit & Loss method-Under this method, closing cash

balance can be known by adding profits for the period to the opening
cash balance because the theory is based on the elementary assumption
that profits of a business are equal to cash. Thus if we assume that there
are no credit transactions, capital transactions, accruals, provisions, stock
fluctuations, or appropriations of profit, the balance of profit as shown
by the profit and loss account should b equal to the cash balance in the
case book. However, such a situation will never exist in actual practice,
the assumption needs adjustments.
Items included are:
(i) All non-cash items shown in the debit side of profit and loss account
should be added to the budgeted profit because these items do not
involve any cash outflows-depreciation, deferred revenue expenditure,
writing off of intangible assets, prepaid expenses etc. 
(ii) Changes in working capital which results in inflow of cash balances
such as increase in closing stock, debtors and decrease in sundry
creditors and other liabilities, redemption of preference shares and
debentures, payment of dividend, purchase capital assets, investment
etc. 

3) Projected Balance Sheet method-Based on the last years balance sheet

we calculate the budget required.

Cash Management Models:

The main objective of cash management is an optimal cash balance;

minimizing the sum of fixed cost of transactions and the opportunity cost of
holding cash balance. Optimal balance here means a position when the cash
balance amount is on the most ideal proportion so that the company has the
ability to invest the excess cash for a return [profit] and at the same time have
sufficient liquidity for future needs. The key ingredient is that the cash balance
should neither be excessive nor deficient.

The minimum cash to hold is the greater of

(1) compensating balances (a deposit held by a bank to compensate it
for providing services) or
(2) precautionary balances (money held in cash for an emergency) plus
transaction balances (money to cover uncleared checks)
The company needs sufficient cash to satisfy daily requirements. Determining
the optimal cash balance is one among the most a crucial task in cash
management area.

How to determine the optimal cash balance? William Baumol and Miller-Orr
offer cash models to determine the optimal cash balance that you can use.

Determining Optimal Cash Balance under Conditions of Certainty

[William Baumol’s Cash Model]:

William Baumol developed a cash model to determine the optimum

amount of transaction cash under conditions of certainty. The objective is to
minimize the sum of the fixed costs of transactions and the opportunity cost of
holding cash balances.

The purpose of this model is to determine the minimum cost amount of

cash that a financial manager can obtain by converting securities into cash,
considering the cost of conversion and the counter balancing cost of keeping the
idle cash balances which otherwise could have been invested in marketable
securities.

The total costs associated with cash management according to this model are
1) Cost of converting marketable securities into cash – These are
incurred each time marketable securities are converted into cash.
Total conversion cost per period = T*b/C
where
b =cost per conversion
T = total cash needs for the time period involved
C = Value of marketable securities sold at each conversion

2) Opportunity cost – This cost is derived from the lost/forfeited interest

rate (i) that could have been earned on the investment of cash
balances. The total opportunity cost is the interest rate times the
average cash balance kept by firm.
i (C/2)
where i = interest rate that could have been earned
C/2 = Average cash balance

The total cost is expressed as:

b [T/C] + i [C/2]
Optimum level of cash balance:

To minimize the cost, the model attempts to determine the optimal conversion
amount, that is, the cash withdrawal which costs the least. The reason is that a
firm should not keep the total beginning cash balance during the entire period as
it is not needed at the beginning of the period. Symbolically the optimal
conversion amount (C) is

C = sqrt (2bT / i)

With the increase in the cost per transaction and total funds required, the
optimum cash balance will increase. However, with an increase in the
opportunity cost, it will decrease.

The model in terms of above equation has important implications. First, as the
total cash needs for transaction rises because of expansion or diversification, the
optimal withdrawal increases less than proportionately. This is the result of
economy of scale in cash management. Secondly, as the opportunity interest
rate increases, the optimal cash withdrawal decreases.

The model clearly and concisely demonstrate the economies of scale and the
counteracting nature of the conversion and opportunity costs which are major
considerations in ant financial manager’s cash management strategy.

Determining Optimal Cash Balance Under Conditions of Uncertainty

[Miller-Orr’s Cash 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,
C = b * E (N) + i * E (M)
t
where b = the fixed cost per conversion
E (M) = the expected average daily cash balance
E (N) = the expected no of conversions
t = no of days in the period
i = the lost opportunity costs
C = total cash management costs

The MO model is an attempt to make the Baumol model more realistic regards
to pattern of cash flows. As against the assumption of uniform and certain levels
of cash balances in the Baumol model, the MO model assumes that cash
balances randomly fluctuate between upper bound (h) and 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 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/converting securities into cash.
According to MO model, as in Baumol model, the optimal cash balance z can
be expressed as

z = Sqrt (3*b*r2/ 4 * i)

where r2 = the variance of daily changes in cash balances

Cash Management Techniques/Processes

There are some specific techniques and processes for speedy collection of
receivables from customers and slowing disbursements.

Speedy Cash Collections

In managing cash efficiently, the cash inflow process can be accelerated through
systematic planning and refined techniques. There are two broad approaches to
do this. In first place, the customers should be encouraged to pay as quickly as
possible. Secondly, the payment from customers should be converted into cash
without any delay.
Prompt Payment by Customers

One way to ensure prompt payment by customers is prompt billing. What the
customer has to pay and the period of payment should be notified accurately
and in advance. The use of mechanical devices for billing along with the
enclosure of a self-addressed return envelope will speed up payment by
customers. Another, and more important, technique to encourage prompt
payment by customers is the practice of offering cash discounts. The avail of the
facility, the customers would be eager to make payment early.

Early Conversion of Payments into Cash

Once the customer makes the payment by writing a cheque in favour of the
firm, the collection can be expedited by prompt encashment of the cheque.
There is a lag between the time a cheque is prepared and mailed by the
customer and the time the funds are included in the cash reservoir of the firm.
Within this time interval three steps are involved, (a).transit or mailing time,
that is, the time taken by the post offices to transfer the cheque from the
customers to the firm. This delay or lag is referred to as postal float. (b).time
taken in processing the cheques within the firm before they are deposited in the
banks, termed as lethargy and (c).collection time within the banks, that is, the
time taken by the bank in collecting the payment from the customer’s bank.
This is called bank float. The early conversion of payment into cash, as a
technique to speed up collection of accounts receivables, is done to reduce the
time lag between posting of the cheque by the customer and the realisation of
money by the firm. The postal float, lethargy and the bank float are collectively
referred to as deposit float. The term deposit float is defined as the sum of
cheques written by customers that are not yet usable by the firm. The collection
of accounts receivables can be considerably accelerated, by reducing transit,
processing and collection time. An important cash management technique is
reduction in deposit float. This is possible if a firm adopts a policy of
decentralised collections. We discuss below some of the important processes
that ensure decentralised collection so as to reduce (a) the amount of time that
elapses between the mailing of the payment by the customer and (b) the point
the funds become available to the firm for use. The principal methods of
establishing a decentralised collection network are (a) concentration banking
and (b) lock-box system.

Concentration Banking
In this system of decentralised collection of accounts receivable, large firms
which have a large number of branches at different places, select some of the
strategically located branches as collection centres for receiving payment from
customers. Instead if all the payments being collected at the head office of the
firm, the cheques for the certain geographical areas are collected a specified
local collection centre. Under this arrangement, the customers are required to
send their payments (cheques) to the collection centre covering the area in
which they live and these are deposited in the local account of the concerned
collection centre, after meeting local expenses, if any.

Lock-Box System

The concentration banking arrangement is instrumental in reducing the time

involved in mailing and collection. But with this system of collection of
accounts receivable, processing for purpose of internal accounting is involved,
that is, some time elapses before a cheque is deposited by the local collection
centre in its account. The lock-box system takes care of this kind of problem,
apart from effecting economy in mailing and clearance times. The customers are
required to remit payments to the post office lock-box. The local banks of the
firm, at the respective places, are authorised to open the box and pick up the
remittances (cheques) received from the customers. Usually, the authorised
banks pick up the cheques several times a day and deposit them in the firm’s
accounts. Thus the lock-box system is like concentration banking in that the
collection is decentralised and is done at the branch level.

Slowing Disbursements

Apart from speedy collection of accounts receivables, the operating cash

requirement can be reduced by slow disbursement of account payable. In fact,
slow disbursement represents a source of funds requiring no interest payments.
There are several techniques to delay payment of accounts payable, namely, (a)
avoidance of early payments, (b) centralised disbursement, (c) floats and (d)
accruals.

Investment of Surplus Funds

Companies often have surplus funds for short periods of time before they are
required for capital expenditures, loan payments, or some other purpose. Instead
of allowing these surplus funds to accumulate in current account where they
earn no interest, companies invest them in a variety of short term instruments
like term deposits with banks, money market mutual funds, and so on.

Investment Portfolio: Three Segments

1. Ready Cash Segment

It represents a reserve for company’s each account. It is meant to
augment the cash resources of the company to meet unanticipated
operational needs. Investment in this segment must necessarily be highly
liquid in nature.

2. Controllable Cash Segment

It represents that part of the investment portfolio which is meant to meet
the needs of knowable outflows like taxes, dividend, interest payments,
and repayments of borrowings. Ideally, investment in this segment must
be matched in size and maturity to known future outflows.

3. Free Cash Segment

It represents that part of investment portfolio which is meant neither to
augment unforeseen current cash needs nor to meet known future
outflows. It essentially represents surplus funds with the firm which has
been invested in short term instruments to generate income, without an
excessive concern for liquidity or maturity.

INVESTMENT OF SURPLUS FUNDS

Companies often have surplus funds for short periods of time before they
are required for capital expenditure, loan repaymnet, or some other purpose
instead of allowing these surplus funds to acccumulate in current account where
they earn no interest, companies invest them in a variety of short-term
instruments like term deposits with banks, money market, mutual funds, and so
on. Managing the investment of surplus funds is a very important responsibility
of the financial manager. This has become more so in recent years, thanks to
higher corporate liquidity and wider range of investment options.

CRITERIA FOR EVALUATING INVESTMENT INSTRUMENTS

Safety, liquidity, yield and maturity are the most important criteria for
evaluating various investment instruments.
1. Safety
Perhaps the most important criterion, safety refers to the probability of
getting back the amount invested. Treasury bills may be regarded as the
safest of all the instruments as they represent the obligations of the
government .The safety of the other instruments depends on the type of
the instruments and the issuer. A high degree of safety is essential for an
instrument to b considered for inclusion in the short term investment
portfolio of the firm.

2. Liquidity
The liquidity of an instrument refers to the ability of the investor to
convert it into cash on short notice without incurring a loss. An
instrument may be quite safe if, it is held till maturity, but it may not be
possible to sell it prematurely without suffering a loss. For a traded
instrument ,a large and active secondary market ensures liquidity. For a
non-traded instrument , liquidity is high if the penalty for premature
liquidation is negligible.

3. Yield

The yield of an instrument is the return earned from it by way of interest,

dividend and capital appreciation. some instrument like Treasury Bills
and commercial papers do not pay interest ,but they are sold at a
discount and redeemed at face value. Yield has to be measured in post-tax
terms ,taking into account ht tax rate applicable to the returns earned by
the investment instrument.

4. Maturity

Maturity refers to the life of the instrument. While some instruments (like
Treasury Bills) have fixed original maturities, others (like certificates of
deposit) can have tailor-made maturity. Generally, the longer the
maturity, the greater the yield.
 INVESTMENT OPTION

1. Commercial Papers

Commercial paper represents short term unsecured promissory

notes issued by firms that are generally considered to be financially
strong. commercial paper usually has a maturity period of 90 days to 180
days .it is sold at a discount and redeemed at par. hence the implicit rate
is a function of the size of discount and the period of maturity.
commercial paper is either directly placed with investors or sold through
dealers. commercial paper does not presently have a well developed
secondary market in india.

The main attraction of commercial paper is that it offers an interest rate

that is typically higher than that offered by treasury bills or certificates of
deposit. however its disadvantage is that it does not have an active
secondary market .hence it makes sense for firms that plan to hold till
maturity.

2. Certificates of Deposits:

A certificate of deposit represent a negotiable receipt of funds deposited

in a bank for a fixed period. It may be in a registered form or a bearer
form. The latter is more popular as it can be transacted more readily in
the secondary market. Unlike treasury bills , cds carry an explicit rate of
interest .the funds deposited earn a fixed rate of interest .on maturity, the
holder of the cd gets the principal amount along with the interest thereon.

CD’s are a popular form of short term investment for companies for the
following reasons:

1.banks are normally willing to tailor the denominations and maturities to suit
the needs of the investors.

2.CD’s are fairly liquid.

3.CD’s are generally risk free.

4.CD’s generally offer a higher rate of interest than treasury bills or term
deposits.
3. Inter –Corporate Deposits

A deposit made by one company with another, normally for a period of

upto six months is referred to as an inter-corporate deposit. such
deposits are usually for three types:

1. Call Deposits: in theory , a call deposit is withdraw able by the lender

on giving a day’s notice in practice, however the lender has to wait for at
least three days.

2. Three Month Deposits: more popular in practice, these depends are

taken by borrowers to tide over a short term cash inadequacy.

3. Six-Month Deposits: normally lending companies do not extend

deposits beyond this time frame such deposits are usually made with first
class borrowers.

STRATEGIES FOR MANAGING SURPLUS FUNDS

The financial managers can consider a series of seven strategies for

handling the excess cash balance with the firm.

1. Do Nothing:
The financial manager simply allows surplus liquidity to accumulate in
the current account. this strategy enhances liquidity at d expense of
profit that could be earned by investing surplus funds.

2. Make Ad-Hoc Investments:

The financial manager makes investments in somewhat ad hoc manner.
such a strategy makes some contribution, though not the optional
contribution, to profitability without impairing the liquidity of the firm.
it is followed by the firms which cannot devote enough time and
resources to management of securities.

3. Ride the Yield Curve:

 This is a strategy to increase the yield from a portfolio of marketable
securities by betting on interest rate charges. If the financial manager
expects that the interest rate will fall in the near future he will buy long
term securities as there appreciate more, compared to shorter term
securities. On the other hand, if the financial manager believes that the
interest rate will increase in the near future ,he would sell long term
securities. This strategy hinges on d assumption that the financial
manager has superior interest rate forecasting abilities.

4. Develop Guidelines:
A firm may develop a set a guidelines which may reflect the view of
management towards risk and return. Examples of such guidelines are:
1. Do not speculate on interest rate charges
2. Do not put more than a certain percentage of liquid funds in a
particular security or instruments.
3. Minimize transaction cost. using a set of guidelines which
supposedly reflect conventional wisdom often provides a ‘satisfying’
solution and not an ‘optimal’ solution. Yet they are found useful by
firms which want liquidity management to be orderly and systematic.

5. Utilise Control Limits:

There are some models of cash management which assumes that cash
inflows and outflows occur randomly 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 marketable securities. By the
same token when the cash balance hits the lower limit, the model says
that a certain amount of marketable securities should be liquidated to
augment the cash resources of the firm.

6. Manage with a portfolio perspective:

According to the portfolio theory there are two key steps in portfolio
selection

a. Define the efficient frontier:

 The efficient frontier represents a collection of all efficient portfolios.
A portfolio is efficient if there is no alternative with
i.same expected return and a lower standard variation or
ii.the same standard deviation and a higher expected return or
iii.a higher expected return and a lower standard deviation.

b. 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. it
is found at the point of tangency between the efficient frontier and a
utility indifference curve.

7. Follow a Mechanical Procedure:

The financial manager may shift funds between a cash account and
marketable securities using a mechanical procedure. Some models
have been developed that provides rules for such mechanical
procedures. The success of such a strategy depends on how well the
behavior on the firm’s cash flows conforms with the assumptions of
the model. It appears that, in practice, mechanical procedures are of
rather limited use.