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CASH MANAGEMENT POLICIES

The purposes of Holding Cash
 The economist John Maynard Keynes identified three reasons for holding cash.
1. Firstly, a business needs cash to meet its regular commitments of paying its accounts
payable, its employees' wages, its taxes, its annual dividends to shareholders and so on.
This reason for holding cash is what Keynes called the transactions motive.
2. Keynes identified the precautionary motive as a second motive for holding cash. This
means that there is a need to maintain a 'buffer’ of cash for unforeseen contingencies.
In the context of a business, this buffer may be provided by an overdraft facility, which
has the advantage that it will cost nothing until it is actually used.
3. Keynes identified a third motive for holding cash – the speculative motive. Some
businesses hold surplus cash as a speculative asset in the hope that interest rates will
rise. However, many businesses would regard large long-term holdings of cash as not
prudent.

 So, How much cash should a company keep on hand or 'on short call' at a bank? The more cash
which is on hand, the easier it will be for the company to meet its bills as they fall due and to
take advantage of discounts.
 However, holding cash or near equivalents to cash has a cost – the loss of earnings which would
otherwise have been obtained by using the funds in another way. The financial manager must
try to balance liquidity with profitability.

Cash flow forecasts

 A cash flow forecast is a detailed forecast of cash inflows and outflows incorporating both
revenue and capital items and as such they are also termed cash budgets as they normally
prepared in advance of the period to which they relate.
 Cash flow forecasts show the expected receipts and payments during a forecast period and are a
vital management control tool, especially during times of recession.
 A cash flow forecast is thus a statement in which estimated future cash receipts and payments
are tabulated in such a way as to show the forecast cash balance of a business at defined
intervals. For example, in December 20X2 an accounts department might wish to estimate the
cash position of the business during the three following months, January to March 20X3. A cash
flow forecast might be drawn up in the following format.

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Jan Feb Mar
$ $ $
Estimated cash receipts
From credit customers 14,000 16,500 17,000
From cash sales 3,000 4,000 4,500
Proceeds on disposal of non-current assets 2,200
Total cash receipts 17,000 22,700 21,500

Estimated cash payments

To suppliers of goods 8,000 7,800 10,500
To employees (wages) 3,000 3,500 3,500
Purchase of non-current assets 16,000
Rent and rates 1,000
Other overheads 1,200 1,200 1,200
Repayment of loan 2,500
Total cash payments 14,700 28,500 16,200
Net surplus/(deficit) for month 2,300 (5,800) 5,300
Opening cash balance 1,200 3,500 (2,300)
Closing cash balance 3,500 (2,300) 3,000

The usefulness of cash flow forecasts

a) The cash flow forecast is one of the most important planning tools that an organisation can use.
It shows the cash effect of all plans made within the flow forecasting process and hence its
preparation can lead to a modification of flow forecasts if it shows that there are insufficient
cash resources to finance the planned operations.
b) It can also give management an indication of potential problems that could arise and allows
them the opportunity to take action to avoid such problems. A cash flow forecast can show four
positions.
c) Management will need to take appropriate action depending on the potential position.

What to include in a cash flow forecast

 A cash flow forecast is prepared to show the expected receipts of cash and payments of cash
during a budget period. It should be obvious that the profit or loss made by an organisation
during an accounting period does not reflect its cash flow position for the following reasons.
a) Not all cash receipts affect statement of profit or loss income.
b) Not all cash payments affect statement of profit or loss expenditure.
c) Some costs in the statement of profit or loss such as profit or loss on sale of non-current
assets or depreciation are not cash items but are costs derived from accounting
conventions.
d) The timing of cash receipts and payments may not coincide with the recording of
statement of profit or loss transactions. For example, a charge for rent or electricity
might be made in respect of
e) 20X6 and shown in the statement of profit or loss for that year, but paid in 20X7.

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Exam focus
A cash flow forecast question could ask you to prepare the cash flow forecast and then recommend
appropriate action for management. Ensure your advice takes account both of whether there is a
surplus or deficit and whether the position is long or short term.

Exercise: Cash flow forecasts

Peter Blair has worked for some years as a sales representative, but has recently been made redundant.
He intends to start up in business on his own account, using $15,000 which he currently has invested
with a building society. Peter maintains a bank account showing a small credit balance, and he plans to
approach his bank for the necessary additional finance. Peter provides the following additional
information.
a) Arrangements have been made to purchase non-current assets costing $8,000. These will be
paid for at the end of September and are expected to have a five-year life, at the end of which
they will possess a nil residual value.
b) Inventories costing $5,000 will be acquired on 28 September and subsequent monthly
purchases will be at a level sufficient to replace forecast sales for the month.
c) Forecast monthly sales are $3,000 for October, $6,000 for November and December, and
$10,500 from January 20X4 onwards.
d) Selling price is fixed at the cost of inventory plus 50%.
e) Two months' credit will be allowed to customers but only one month's credit will be received
from suppliers of inventory.
f) Running expenses, including rent but excluding depreciation of non-current assets, are
estimated at $1,600 per month.
g) Blair intends to make monthly cash drawings of $1,000.

Required
Prepare a cash flow forecast for the six months to 31 March 20X4.

Exercise 2
From the following information which relates to George and Zola Co you are required to prepare a
month by month cash flow forecast for the second half of 20X5 and to append such brief comments as
you consider might be helpful to management.
a) The company's only product, a vest, sells at $40 and has a variable cost of $26 made up of
material $20, labour $4 and overhead $2.
b) Fixed costs of $6,000 per month are paid on the 28th of each month.
c) Quantities sold/to be sold on credit
May June July Aug Sept Oct Nov Dec
1,000 1,200 1,400 1,600 1,800 2,000 2,200 2,600

d) Production quantities
May June July Aug Sept Oct Nov Dec
1,200 1,400 1,600 2,000 2,400 2,600 2,400 2,200

e) Cash sales at a discount of 5% are expected to average 100 units a month.

f) Customers settle their accounts by the end of the second month following sale.
g) Suppliers of material are paid two months after the material is used in production.

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h) Wages are paid in the same month as they are incurred.
i) 70% of the variable overhead is paid in the month of production, the remainder in the following
month.
j) Corporation tax of $18,000 is to be paid in October.
k) A new delivery vehicle was bought in June. It cost $8,000 and is to be paid for in August. The old
vehicle was sold for $600, the buyer undertaking to pay in July.
l) The company is expected to be $3,000 overdrawn at the bank at 30 June 20X5.
m) No increases or decreases in raw materials, work in progress or finished goods are planned over
the period.
n) No price increases or cost increases are expected in the period.

Methods of easing cash shortages

 Cash shortages can be eased by postponing capital expenditure, selling assets, taking longer to
pay accounts payable and pressing accounts receivable for earlier payment. The steps that are
usually taken by a company when a need for cash arises, and when it cannot obtain resources
from any other source such as a loan or an increased overdraft, are as follows.
a) Postponing capital expenditure - Some new non-current assets might be needed for the
development and growth of the business, but some capital expenditures might be
postponable without serious consequences. If a company's policy is to replace company
cars every two years, but the company is facing a cash shortage, it might decide to
replace cars every three years.
b) Accelerating cash inflows which would otherwise be expected in a later period One way
would be to press accounts receivable for earlier payment. Often, this policy will result
in a loss of goodwill and problems with customers. It might be possible to encourage
credit customers to pay more quickly by offering discounts for earlier payment.
c) Reversing past investment decisions by selling assets previously acquired Some assets
are less crucial to a business than others. If cash flow problems are severe, the option of
selling investments or property might have to be considered. Sale and leaseback of
property could also be considered.
d) Negotiating a reduction in cash outflows, to postpone or reduce payments

Treasury management
 A large organisation will have a treasury department to manage liquidity, short-term
investment, borrowings, foreign exchange risk and other, specialised, areas such as forward
contracts and futures etc.
 Treasury management can be defined as: 'The corporate handing of all financial matters, the
generation of external and internal funds for business, the management of currencies and cash
flows, and the complex strategies, policies and procedures of corporate finance.' (Association of
Corporate Treasurers)
 Large companies rely heavily on the financial and currency markets. These markets are volatile,
with interest rates and foreign exchange rates changing continually and by significant amounts.
To manage cash (funds) and currency efficiently, many large companies have set up a separate
treasury department.

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 A treasury department, even in a large organisation, is likely to be quite small, with perhaps a
staff of three to six qualified accountants, bankers or corporate treasurers working under the
treasurer.

Centralisation of the treasury department

The following are advantages of having a specialist centralised treasury department.
a) Centralised liquidity management avoids having a mix of cash surpluses and overdrafts in
different localised bank accounts and as well facilitates bulk cash flows, so that lower bank
charges can be negotiated.
b) Larger volumes of cash are available to invest, giving better short-term investment opportunities
for example money markets, high-interest accounts and CDs).
c) Any borrowing can be arranged in bulk, at lower interest rates than for smaller borrowings, and
perhaps on the euro-currency or euro-bond markets.
d) Foreign exchange risk management is likely to be improved in a group of companies. A central
treasury department can match foreign currency income earned by one subsidiary with
expenditure in the same currency by another subsidiary. In this way, the risk of losses on
adverse exchange rate movements can be avoided without the expense of forward exchange
contracts or other hedging methods.
e) A specialist treasury department can employ experts with knowledge of dealing in forward
contracts, futures, options, euro-currency markets, swaps and so on. Localised departments
could not have such expertise.
f) The centralised pool of funds required for precautionary purposes will be smaller than the sum
of separate precautionary balances which would need to be held under decentralised treasury
arrangements.
g) Through having a separate profit centre, attention will be focused on the contribution to group
profit performance that can be achieved by good cash, funding, investment and foreign currency
management.

Possible advantages of decentralised cash management are as follows.

a) Sources of finance can be diversified and can match local assets.
b) Greater autonomy can be given to subsidiaries and divisions because of the closer relationships
they will have with the decentralised cash management function.
c) A decentralised treasury function may be more responsive to the needs of individual operating
units.
d) Since cash balances will not be aggregated at group level, there will be more limited
opportunities to invest such balances on a short-term basis.

Cash management models

 Optimal cash holding levels can be calculated from formal financial management models, such
as the Baumol model and the Miller-Orr model.
 A number of different cash management models indicate the optimum amount of cash that a
company should hold.

The Baumol model

 The Baumol model is based on the idea that deciding on optimum cash balances is like deciding
on optimum inventory levels. It assumes that cash is steadily consumed over time and a

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business holds a stock of marketable securities that can be sold when cash is needed. The cost
of holding cash is the opportunity cost, i.e. the interest foregone from not investing the cash.
The cost of placing an order is the administration cost incurred when selling the securities.
 The Baumol model uses an equation of the same form as the EOQ formula for inventory
management which we looked at earlier. Similarly to the EOQ, costs are minimised when:

Quantity = square root of (2CS ÷ i) = $/period

Where S = the amount of cash to be used in each time period

C = the cost per sale of securities
i = the interest cost of holding cash or near cash equivalents
Q = the total amount to be raised to provide for S

Example: Baumol approach to cash management

Finder Co faces a fixed cost of $4,000 to obtain new funds. There is a requirement for $24,000 of cash
over each period of one year for the foreseeable future. The interest cost of new funds is 12% per
annum; the interest rate earned on short-term securities is 9% per annum. How much finance should
Finder raise at a time?

Drawbacks of the Baumol model

a) The inventory approach illustrated above has the following drawbacks.
b) In reality, it is unlikely to be possible to predict amounts required over future periods with much
certainty.
c) No buffer inventory of cash is allowed for. There may be costs associated with running out of
cash.
d) There may be other normal costs of holding cash which increase with the average amount held.

The Miller-Orr model

 In an attempt to produce a more realistic approach to cash management, various models more
complicated than the inventory approach have been developed. One of these, the Miller-Orr
model, manages to achieve a reasonable degree of realism while not being too elaborate.
 We can begin looking at the Miller-Orr model by asking what will happen if there is no attempt
to manage cash balances. Clearly, the cash balance is likely to 'meander' upwards or
downwards. The Miller-Orr model imposes limits to this meandering.
 If the cash balance reaches an upper limit (point A) the firm buys sufficient securities to return
the cash balance to a normal level (called the 'return point'). When the cash balance reaches a
lower limit (point B), the firm sells securities to bring the balance back to the return point.

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