 The management of cash

 Cash flow forecasts

 Treasury management
 Cash management models

Working Capital Finance

 Investing surplus cash
 Working capital funding strategies
Overview – working capital finance

Maximisation of
shareholder wealth

Investment Financing
o n s
Dividend decision
decision decision
So luti
rni ng
r tex Lea
Ve
Cash forecasting Cash forecasting
Finance to fund
to plan how to to ensure that
investments
deal with cash dividends can be
in working capital
shortages paid

https://vls-online.com
 Syllabus learning outcomes (1)
• Various reasons for holding cash, and discuss and apply the use of
relevant techniques in managing cash, including:
(i) Preparing cash flow forecasts to determine future cash flows
and cash balances
(ii) Assessing the benefits of centralised tio ns
treasury management
and cash control S o lu
nin g
r such as the Baumol model and
(iii) Cash management x Le a
models,
e rte
V model
the Miller-Orr
(iv) Investing short-term

https://vls-online.com
 Syllabus learning outcomes (2)
• Calculate the level of working capital investment in current assets
and discuss the key factors determining this level, including:

(i) The length of the working capital cycle and terms of trade
o n s
tiof investment in current
(ii) An organisation's policy on the level
S o lu
assets r nin g
x Le a
erintewhich the organisation operates
(iii) The industry
V

https://vls-online.com
Syllabus learning outcomes (3)
• Key factors in determining working capital funding strategies,
including:
(i) The distinction between permanent and fluctuating
current assets
(ii) The relative cost and risk of short-termtio ns
and long-term
finance S o lu
r nin g
(iii) The matching e x Le a
principle
e rt
V costs and benefits of aggressive, conservative
(iv) The relative
and matching funding policies
(v) Management attitudes to risk, previous funding decisions
and organisation size
 Key models and theories
The previous two chapters on working capital introduced the concepts
of liquidity and working capital and also described how inventory,
receivables and payables can be managed.

n s
othe key ingredient to
This chapter looks at the management of cash: luti
survival. g So
rni n
L ea
r tex
There are two modelsVtoe be aware of:
• Baumol
• Miller Orr
 The nature of cash
'Cash is king'
• Cash is ready money in the bank or in the
business. Unlike inventory and receivables, it
can be used to pay wages, rent and suppliers.
o ns
• luti
Having good profits does not necessarily mean
that a business has enough g So
cash.
rnin
• Monitoring cash inflowsL ea and outflows to ensure
that there is enough
r tex cash is one of the most
Ve
important management tasks for any business.
• Ultimately it is a lack of cash when it’s needed
that causes a business to fail.

https://vls-online.com
 Reasons for holding cash
There are three reasons (or motives) for holding cash:

• Transactions motive: to meet the day-to-day transactions of running a

business s
ti n
o events such as a large
• Precautionary motive: as a safety net for unexpected
So lu
n g of credit will also provide this
customer failing. An overdraft facility or iline
a rn
safety.
x L e
• Speculative motive: to take r te
e advantage of opportunities eg bulk buy discounts
V
or investment in a new line of business when the opportunity arises.

https://vls-online.com
 Cash flow problems
Cash flow problems can arise for the following reasons:
• Making losses: this can eventually lead to failure.
• Inflation: asset costs increase and will be expensive to replace
• Growth: cash is needed to provide inventory and fund
o ns receivables as
businesses grow. (Note overtrading.) luti
g So
rni n
• Seasonal businesses: for example agriculture where there are outflows in
spring and inflows at harvest x Lea
r te
Ve for example tax, dividends, legal costs
• One-off items of expenditure:

https://vls-online.com
 Cash flow forecasts
Cash flow forecasts (or cash flow budgets) are the key tool when managing cash.

• They should include both revenue and capital flows.

• Careful attention needs to be paid to the timing of o s
a nreceipt or payment.
luti
• They should be based on the budgeted statement
g So of profit or loss and
statement of financial position. rni n
L ea
• x statement in advance.
Essentially we are producing taebank
Ver

https://vls-online.com
Cash flow forecasts – typical layout
January February March
Receipts:
Cash sales x x x
From credit customers x x x
Total receipts R R R
o ns
Payments x
uti x x
Suppliers x
ng Sol x x
Wages
rnix x x
L ea
Other expenses
r tex x x x

V e
Tax/dividends/non-current assets x x x
Total payments P P P
Cash b/f x x x
Net of receipts and payments R-P R-P R-P
Cash c/f X X X
 Cash flow forecasts – timings
• Correct timings of receipts from customers and payments to suppliers are essential.

• In the exam, these calculations are not difficult but they are repetitive and, initially,
care is needed to get started correctly.
o ns
luti
S o
• ni n g
le a r
It is essential to provide clear workings both to help your accuracy and so that a
marker can follow what you rtex
have done.
V e

https://vls-online.com
Simple cash flow extract to try
What cash inflows will arise for January, February and March
from the sales figures and other information below?
$'000 Oct Nov Dec Jan Feb Mar
Sales 100 120 160 80 90 100
ti o ns
i ng Solu
L e a r n
rtex
Customers pay as
Ve
follows:
30% after one month
60% after two months
5% after three months
5% never received
Answer to simple cash flow extract
30% after 1 month; 60% after 2 months; 5% after 3 months; 5% never received

$000 Oct Nov Dec January February March

Sales 100 120 160
30%
80 90 100
1 month 48 24 27
60%
2 months 72 96 48
5%
3 months ns 5
tio 125
6 8
Totals So lu 126 83
r ning
x Le a
erteand accuracy, work horizontally. Once
Note: for efficiency
V
you have decided that 30% of December's sales are
received in January, move to February and March using the
same time delay. Don’t complete all of January, then all of
February.
Question – Which amounts appear where?

Not every aspect of the statement of profit or loss amount will

have cash flow consequences. Similarly, some SOFP items will
affect the cash flow forecast.
Which of the following will appear on a cash flow forecast?
ti o nsYes/no
i ngSolu
L e a n
r provision
Increase rintex
receivables
Ve
Purchase of non-current assets
Depreciation
Taxation
Accrual
Dividends
Answer – Which amounts appear where?

Which of the following will appear on a cash flow forecast?

Yes/no

Increase in receivables provision No – there is no cash movement when

provisions are changed
Purchase of non-current assets Yes s
uti on
Depreciation No
S o– ldepreciation is not a cash flow
r ningYes – tax paid is a cash flow
Taxation paid
L e a
Accrual e r tex No – by definition an accrual has not
V been paid
Dividends paid Yes – dividends paid are cash items
 Use of opening SOFP figures
A question could give you an opening statement of financial position and ask you
to work out initial receipts and payments from that.

Then sales and purchases forecasts will become relevant.

s
tio n
So lu
i ng
For example…
a rn
x L e
e r te
V

https://vls-online.com
 Question – use of opening SOFP figures
SOFP extract as at 31/12/20X3:
$ million
Receivables 270
Trade payables 120
ti o ns
Solu
i ng
Sales in 20X3 were constant peremonth
L a n
r and customers take three months' credit;
x
ertemonths.
suppliers are paid after Vtwo
How much will be received from customers and paid to suppliers in January and
February 20X4?
 Answer – use of opening SOFP figures
SOFP extract as at 31/12/20X3: Receivables 270; Trade payables 120
Sales in 20X3 were constant per month and customers take three months' credit; suppliers are paid after two
months.

Receivables of 270 represent three month's sales (Oct, Nov, Dec) so (270/3=)
90/month will be received in Jan, Feb and March 20X3.
ti ons
ing Solu
Payables of 120 represent two months'
e ar n purchases (Nov, Dec) so (120/2=)
t L
ex Feb.
e
60/month will be paid in Jan
V r and
 Dealing with cash shortages
• Postpone capital expenditure.
• Try to accelerate inflows (eg discounts).
• Try to slow down or renegotiate payments. For example:
• Take longer credit (but don't upset suppliers!) ns
utio
• Renegotiate loan repayment So l
i ng
• Reduce or postpone dividend paymentsa rn
L e
• Liquidate inventory by havingrtaexsale
Ve
• Try to sell surplus assets. For example, sell vehicles to a fleet management
company and rent them back.
• Finance – reschedule loans, reduce dividends, raise loan/equity finance if time
allows
 Cash flow forecasts and uncertainty
• Cash flow forecasts depend on estimating future sales, purchases, cash
receipts and cash payments.
• These are inherently uncertain.
Therefore: s
ti n
oand most accurate data
• Review cash forecasts regularly and use the o
S lu
latest
available. i ng
a rn
• L e
Examine the sensitivity of cash xbalances to assumptions about the timing and
amount of cash flows. Verte
• Ensure sufficient contingent funds are available
• Questions can assign probabilities to certain flows occurring.
June 2010 Q1
Period 1 cash flow Probability Period 2 cash flow Probability
$'000 $'000
8,000 10% 7,000 30%
4,000 60% 3,000 50%
(2,000) 30% (9,000) 20%

tio ns
Calculate the following values:ning Solu
L ear
(i) The expected value
e r tex of the period 1 closing balance
V
(ii) The expected value of the period 2 closing balance
(iii) The probability of a negative cash balance at the end of period 2
(iv) The probability of exceeding the overdraft limit at the end of
period 2
Overdraft limit = $2 million; opening balance = $500,000 overdrawn
 June 2010 Q1 Hints
Expected value of cash balances at end of period 1
= (P1 × Cash balance 1) + (P2 × Cash balance 2) + …….

Expected value of cash balances at end of period 2 will require you to consider
each of the three outcomes at the end of period
tio ns1 and to follow through with each
of the outcomes of period 2 …… o lu
gS
nin
L e ar
r tex
Ve
 June 2010 Q1 (1)
The expected value of the period 1 closing balance

Opening Cash flow Closing Probability Expected

balance balance value
(500) 8,000 7,500 0.1 750
(500) 4,000 3,500
o ns
ti 0.3
0.6 2,100
(500) (2,000) So
(2,500) lu ( )
ning 750
L e ar 2,100
r tex
Ve
June 2010 Q1 (2)
The expected value of the period 2 closing balance
Period 1 Period 2 P Period 2 Joint Expected
closing bal Cash flow closing bal prob value
7,000 0.3 14,500 0.03 435
7,500 with a 3,000 0.5 10,500 0.05 525
0.1 prob
(9,000) 0.2 (1,500) 0.02 (30)
tio ns0.18
7,000 0.3 lu
10,500
S o 1,890
3,500 with a
ning 6,500
0.6 prob
3,000
a r
0.5
Le0.2 (5,500)
0.30 1,950
r tex
(9,000) 0.12 (660)
V e
7,000 0.3 4,500 0.09 405
(2,500) with 3,000 0.5 500 0.15 75
a 0.3 prob
(9,000) 0.2 (11,500) 0.06 (690)

Expected balance at end of period 2 = 3,900

June 2010 Q1 (3)
Probability of negative cash at end of period 2
Period 1 Period 2 P Period 2 Joint Expected
closing bal. Cash flow closing bal. prob value
7,000 0.3 14,500 0.03 435
7,500 with a 3,000 0.5 10,500 0.05 525
0.1 prob
(9,000) 0.2 (1,500) ns 0.02 (30)
lutio
7,000 0.3 g o
S10,500 0.18 1,890
3,500 with a r ni n
3,000Lea 0.5 6,500 0.30 1,950
0.6 prob r tex
Ve(9,000) 0.2 (5,500) 0.12 (660)
7,000 0.3 4,500 0.09 405
(2,500) with 3,000 0.5 500 0.15 75
a 0.3 prob
(9,000) 0.2 (11,500) 0.06 (690)

0.02 + 0.12 + 0.06 = 0.20 or 20%

June 2010 Q1 (4)
Probability of exceeding overdraft ($2 million)
Period 1 Period 2 P Period 2 Joint Expected
closing bal. Cash flow closing bal. prob value
7,000 0.3 14,500 0.03 435
7,500 with a 3,000 0.5 10,500 0.05 525
0.1 prob
(9,000) 0.2 (1,500) s0.02 (30)
tio n
7,000 0.3 olu
10,500
S 0.18 1,890
3,500 with a ning
0.6 prob
3,000
Le ar
0.5 6,500 0.30 1,950
r tex
Ve
(9,000) 0.2 (5,500) 0.12 (660)
7,000 0.3 4,500 0.09 405
(2,500) with 3,000 0.5 500 0.15 75
a 0.3 prob
(9,000) 0.2 (11,500) 0.06 (690)

Probability = 0.12 + 0.06 = 0.18 or 18%

Treasury management
A large organisation will have a separate, specialised
treasury department typically to manage:

• Liquidity s
tio n
• Short-term investment
So lu
• i ng
Borrowings
a rn
• Foreign exchange risk x L e
r te
• Ve such as forward contracts and futures
Specialised areas
Advantages centralising the treasury function

Precautionary motive
accomplished on a
Expertise group basis Profit centre
motivation
s
tio n
Cash pooled to Centralised o lu
S Borrowing needs
i ng pooled to get
get better rn
treasury
a
L e better rates
returns
texfunction
Ver
Foreign currency risk
Overdrafts and
assessed on group
surpluses can be
basis – match inflows
netted off
and outflows
Potential advantages of decentralisation
Better matching to local
assets

Greater autonomy o ns
uti
for local managers Decentralised
ng Sol Opportunities for
rn
treasury i fast, specialised
L ea solutions
texfunction
Ver

Better matching
to local needs
Cash management model: Baumol (1)
The Baumol model considers a business needing a
certain amount of cash per time period, and works
out the most economical way to raise the cash.
• If a lot of cash is raised in one go, then there will
be a high cost of servicing that cash o ns
(eg
uti
l all be needed
interest), even though it might
g Sonot
immediately. rni n
L ea
t ex
• If cash is raised frequently in small amounts,
Ver
then the transaction costs will be high.
• The model is analogous to the economic order
quantity model for inventory where there is a
compromise between high holding costs and high
ordering costs.
Cash management model: Baumol (2)

√
Q = 2CS
i
where:

Q = the amount to be borrowed/drawn down each time

C = the cost of raising the cash eg the cost ofs selling
securities to receive cash tio n
S = amount of cash used in each time So lu
period
i g
in or cash equivalents
= interest cost of holding ncash
ea r
ex L
There is a formula sheet
e r t in F9, but it does not contain this
formula. However,Vit is unlikely that a question would be
asked on this without giving the formula. That said, it
probably won’t tell you what the symbols mean! Note that
it is very similar to the EOQ formula.
Question – Baumol model
Q = the amount of cash to be raised
Q= 2CS
√ i
C = the cost of raising the cash eg the cost of selling
securities to receive cash
S = amount of cash used in each time period
i = net interest cost of holding cash or cash equivalents

ti o ns
i ng Solu
Raising funds costs a company
L a r n a fixed amount of $12,000. An
eyear needs to be raised to cover new
amount of $150,000
erte xper
V
investment. The interest cost of new funds is 9% and cash can
be deposited at 5%. How much finance should be raised at a
time?
 Answer – Baumol model
Q = the amount of cash to be raised
C = the cost of raising the cash eg the cost of selling
Q = 2CS securities to receive cash
i
S = amount of cash used in each time period
i = net interest cost of holding cash or cash equivalents

Raising funds costs a company a fixed amount of $12,000. An amount n ofs$150,000 per year needs to be raised to cover
new investment. The interest cost of new funds is 9% and cash o
lutibe deposited at 5%
g S ocan
arnin
ex Le
Ve r t
Q = 2CS = 2 × 12,000 × 150,000 = 300,000
i 0.09  0.05
So raise $300,000 every two years (as $150,000 needed per year).
Problems with the Baumol model
Problems with the Baumol model include:

• Future cash needs are unlikely to be constant.

• The cost of holding cash is likely to change o nsfrequently as
interest rates fluctuate. luti
So
g to fluctuate with the
• n i
The cost of holding cash is rlikely n
amount of cash on deposit L ea ie large deposits attract
x
higher interest. Verte
• No account is taken of keeping buffer (safety) cash.
The Miller-Orr model (1)
The Miller-Orr model seeks to control the limits between
which cash balances move.

• Too much cash wastes money (it should bes earning a

return) tio n
So lu
• Too little risks running out of cash
i ng so increases risk
a rn
• Cash balances are adjusted
x L e by buying and selling
r te
e cash to and from deposit
securities (or moving
accounts)
V
The Miller-Orr model (2)
Cash
Upper limit

Securities
bought ns
o Return point
uti
ng Sol
rni
L ea Securities sold

r tex Lower limit

Ve
Time
Cash is allowed to fluctuate between the upper and lower limits.
When a limit is reached, securities are bought or sold to restore
cash to the return point.
The Miller-Orr model (3)
Cash is allowed to fluctuate between the upper and lower
limits. When a limit is reached, securities are bought or sold to
restore cash to the return point.
The spread is the difference between the upper or lower limit,
and is given by: o ns
lu ti
g So
 3 transaction cost × variance of the cash flows  3
1
3 ×
4 rni n
interest rate 
Spread = 
L ea 

r tex
Return point = e
VLower limit + (1/3 × spread)
Time
Note: this model does not set the lower limit for the cash
fluctuations. Note also, interest rate is usually daily interest rate.
The Miller-Orr model (4)
1
Spread = 3  3× transaction cost × variance of the cash
 flows  3

4 interest rate 

Return point = Lower limit + (1/3 × spread)

o ns
1 Set the lower limit eg based on caution,tiprecautionary
motive and experience. S o lu
i ng flows (variance = the
n
2 Estimate the variance of the rcash
a
L e
square of the standardxdeviation).
r te
e and the transaction cost.
3 Find the interest Vrate
4 Calculate the spread.
5 The return point is the lower limit + 1/3 the spread.
6 The upper limit is the lower limit plus the spread.

The variance or standard deviation will be supplied in any

question, along with the other variables.
Question – the Miller-Orr model
1
 3 transaction cost × variance of the cash flows  3
Spread = 3 × 
4 interest rate
 
Return point = Lower limit + (1/3 × spread)

A company has set its lower limit at $10,000.

The standard deviation of the daily cash ti o n s is $1,500.
flows
g S olu
The cost of buying or selling
a r ni n
securities is $40.
ex Leper cent per day.
The interest rate isrt0.02
Ve
What are the spread, the lower limit, the upper limit and the
return point?
Answer – the Miller-Orr model
1
Spread = 3  3× transaction cost × variance of the cash flows  3

4 interest rate
 
Return point = Lower limit + (1/3 × spread)
A company has set its lower limit at $10,000. The standard deviation of the daily
cash flows is $1,500. The cost of buying or selling securities is $40.
The interest rate is 0.02 per cent per day. s
ti on
ing  3 S1olu
Spread =  3 40 × 1,500 a
e n
×r1,500
 4,500
3 ×
4 e x L 

 Vert 0.02 
Lower limit = $10,000; upper limit =$14,500; return point
(10,000 + (1/3 x 4,500)) = $11,500
The Miller-Orr model (5)
1
Spread = 3  3× transaction cost × variance of the cash flows  3

4 interest rate
 
Note:
• High transaction costs mean the spread is high to prevent
excessive expensive transactions. o ns
lu ti
• A high variance means the natural S o
variations are high and
g transactions
i n
the range is large to prevent r'nervous'
n
• If the interest rate is high,L ea
the range will be low to prevent
r tex
e
too much surplusVcash
• To keep interest costs down, the return point is only 1/3 of
the range up from the lower limit
 Investing surplus cash
Some companies are in the fortunate position of having surplus cash:

• In March 2013 Apple had $137 billion cash on deposit (about 10% of all US
companies' corporate cash).

• Companies with more modest amounts should be investing surplus cash to

earn interest.

https://vls-online.com
 Investing surplus cash – considerations
• Leave enough in a current account or on short term deposit to ensure
adequate liquidity
• Look for returns commensurate with risk
• Avoid capital losses s
ti n
o might take to realise any
• Think carefully about deposit terms and how o
S lu
long it
investment i ng
a rn
• L
Are international markets attractive?
x e
r te
• Ve a minimum amount?
Do some investments require
 Investing surplus cash – considerations
If surplus cash seems to be permanent and the company cannot devise a way of
using it, then the company should consider returning it to investors to allow them
to invest elsewhere.
In April 2013, as a response to shareholder criticism, Apple announced:
• A 15% increase in its dividend
• A share buy-back scheme worth $60 billion
Special dividends (income) and share buy-backs (capital gains) are the standard
ways of returning cash to investors.
 Where to invest surplus cash
• Short term investments, such as bank deposits, tradable debt instruments or
listed shares
• Money market lending
• Certificates of deposit s
tio n
• Treasury bills ol uS
g
ea rnin
ex L
r t
Ve
Working capital funding strategies (1)
Working capital can be funded by a mixture of
• Short-term funding
• Long-term funding
Businesses should be aware of the distinction o nsbetween
fluctuating and permanent assets. luti
So
gamount required to
Permanent current assets are rn i
then
L e
meet long-term minimumxneeds.a
r te
Fluctuating currentVeassets are the current assets which
vary according to normal business activity.
Permanent assets should be funded with long-term capital.
Fluctuating assets can be funded by short-term capital.
Working capital funding strategies (2)
Assets A, B and C are
A the possible
cut-offs
Fluctuating current assets between
oCns long-term
uti
Sol B
and short-
i ng term finance
rn
Permanent current assets
a
x L e
e r e
t Non-current assets
V
Time

Companies can choose the balance of long term and short term funding
they want to use for non-current, permanent current assets and
fluctuating current assets.
Working capital funding strategies (3)
Assets A, B and C are
A the possible
cut-offs
Fluctuating current assets between
oCns long-term
uti
Sol B
and short-
i ng term finance
rn
Permanent current assets
a
x L e
e r e
t Non-current assets
V
Time

Policy A (conservative approach): most funding is long-term, with

little reliance on short-term finance – despite assets often falling
below what the permanent funding supports. Safe but wasteful.
Working capital funding strategies (4)
Assets A, B and C are
A the possible
cut-offs
Fluctuating current assets between
oCns long-term
uti
Sol B
and short-
i ng term finance
rn
Permanent current assets
a
x L e
e r e
t Non-current assets
V
Time

Policy B (an aggressive approach): most funding is short-term. Long-term

capital covers non-current assets but most funding of current assets, even
'permanent current assets' relies on short-term sources. Risky but profitable.
Working capital funding strategies (5)
Assets A, B and C are
A the possible
cut-offs
Fluctuating current assets between
oCns long-term
uti
Sol B
and short-
i ng term finance
rn
Permanent current assets
a
x L e
e r e
t Non-current assets
V
Time

Policy C (a balanced approach): permanent current assets and non-current

assets are funded by long-term capital. Fluctuating current assets are funded
by short-term capital (such as overdrafts).
 Other factors
Working capital levels are also affected by:
• Industry norms. For example, what the normal receivables
and payables periods are for the industry. Straying too far
from these might make the company uncompetitive.
• Industry type. Erratic sales implies more working
o ns capital is
luti
needed for the bad times.
g S o
• The manufacturing process.rnLong in manufacturing times
L ea
implies high amounts ofxwork-in-progress
r te
• Management issues.Ve For example, attitude to risk, quality of
the information systems. Eg if poor, buffer inventories may be
needed.

https://vls-online.com