Cash

Cash Management
Management

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 Cash Management
Learning objectives
 Cash Management
 Motives for holding cash
 Cash Budget
 Different types of “Float”
 Managing collection and disbursement of cash.
 Cash conversion cycle
 Baumol & Miller-orr Model

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 Cash Management

The managing of cash flows is an extremely important task for

a financial managers. Part of the task is determining how much
cash a firm should have on hand at any time to ensure normal
business operations continue uninterrupted. So, Cash flow
management is the process of monitoring, analyzing, and
adjusting the organization’s cash
Ways to Manage Cash
Firms can manage cash in virtually all areas of operations that
involve the use of cash. The goal is to receive cash as soon as
possible while at the same time waiting to pay out cash as
long as possible.
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 Cash inflows and Outflows
Ideally, during the business cycle, most businesses will
have more money flowing in than flowing out. This will
allow the firm to build up cash balances with which to plug
cash flow gaps, seek expansion and reassure lenders and
investors about the health of the business.
It is important to know that income and expenditure cash
flows rarely occur together, with inflows often lagging
behind. Firm’s aim must be to speed up the inflows and
slow down the outflows.

Cash inflows occur from following activities

 Payment for goods or services from your customers.
 Receipt of a bank loan.
 Interest on savings and investments.
 Shareholder investments.
 Increased bank overdrafts or loans.
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 Cash inflows and Outflows
Cash outflows occur from following activities

 Purchase of stock, raw materials or tools.

 Wages, rents and daily operating expenses.
 Purchase of fixed assets - PCs, machinery, office furniture,
etc.
 Loan repayments.
 Dividend payments.
 Income tax, corporation tax, VAT and other taxes.
 Reduced overdraft facilities.
 Many of your regular cash outflows, such as salaries, loan
repayments and tax, have to be made on fixed dates. You
must always be in a position to meet these payments in
order to avoid large fines or a disgruntled workforce.
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 Motives behind holding Cash
Why Firms Hold Cash?
The finance profession recognizes the three primary reasons offered
by economist John Maynard Keynes to explain why firms hold cash.
The three reasons are for the purpose of speculation, for the
purpose of precaution, and for the purpose of making
transactions. All three of these reasons stem from the need for
companies to possess liquidity.
Transaction motive
Firms are in existence to create products or provide services. The
providing of services and creating of products results in the need for
cash inflows and outflows. Firms hold cash in order to satisfy the
cash inflow and cash outflow needs that they have. These are
basically to meet payments, such as purchases, wages, taxes,
dividends, arising in the ordinary course of business. 6
 Motives behind holding Cash

Precautionary motive
Holding cash as a precaution serves as an emergency fund for a firm. If expected
cash inflows are not received as expected cash is held on a precautionary basis. It
acts as a safety cushion or buffer to meet unexpected cash needs. The more
predictable the inflows and outflows of cash for a firm , the less cash that needs to
be held for precautionary needs. Ready borrowing power to meet emergency cash
drains also reduces the need for this type of cash balance.
Firms must hedge against the possibility of unexpected needs:
Options for short term bank deposit
Hold interest bearing Short term investments. (short term maturity)

Trade Offs:
Interest revenue from the above two options.
Transaction costs involved in purchasing and selling such near cash assets.
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 Motives behind holding Cash
Speculative motive
Economist Keynes described this reason for holding cash as creating the ability
for a firm to take advantage of special opportunities that if acted upon quickly will
favor the firm. An example of this would be purchasing extra inventory at a
discount that is greater than the carrying costs of holding the inventory.
If the firm experience seasonality in sales, then there will be times during the year
when such firm will have excess cash, that will be needed later in the year.
Investment Strategy:
Buy back existing bond & stocks when there is excess cash
Investment in fixed assets
 Participate in Mergers & Acquisitions
Issue bond when needed
Short term investments.
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 Cash Flow Management

Here are a few guidelines to help manage cash flow more

effectively:
Collect money from debtors (A/R) as quickly as possible.
Centralize payments system for different functional areas
such as accounts payable and payroll.
Develop close partnerships with customers and suppliers to
negotiate mutually beneficial payment policies.
Develop banking relationships by choosing banks that can
offer customized cash management services. You will get
advice from banking experts and save on bank charges.

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 Cash Flow Management

Develop cash flow forecasting techniques and models that

are linked to budgets and strategic plans.
Conduct regular reviews of the cash situation to ensure that
the cash balances are approximately the same as in the
budget,and analyze any significant variations from budget.
Ensure appropriate use of current technology: for example,
telephone and internet banking as these are quicker and
cheaper.
Ensure that investing, borrowing, payment and other
financial transactions are properly authorized so as to avoid any
improper use of the organization's cash.

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 Cash Budget
 Cash Budget: A schedule showing cash receipts, cash
disbursements, and cash balances for a firm over a specific time
period.
 Perhaps the most critical ingredient to proper cash management is the
ability to estimate the cash flows of the firm so the firm can make plans
to borrow when cash is deficient or to invest when cash is in excess of
what is needed. So, without the doubt financial managers must rely on
the most important tool for managing cash and that is cash budget
(forecast). The cash budget helps management plan investment and
borrowing strategies, and it also is used to provide feedback and
control to improve the efficiency of cash management in the future.
 The firm estimates its general needs for cash as part of its overall
budgeting, or forecasting, process. First, the firm forecasts its operating
activities such as expenses and revenues for the period in question.
Then, the financing and investment activities necessary to attain the
level of operations must be forecasted. Such forecasts entail the
construction of pro forma financial statements.

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 Cash Budget
 The information provided from the pro forma balance sheet
and income statement is combined with projections about
the delay in collecting accounts receivables, the delay in
paying suppliers and employees, tax payment dates,
dividend and interest payment dates, and so on. All of this
information is summarized in the cash budget, which
shows the firm’s projected cash inflows and outflows,
financing over some specified period. Generally, firms use
a monthly cash budget forecasted over the next year plus
more detailed daily or weekly cash budget for the coming
month. The monthly cash budgets are used for planning
purposes and the daily or weekly budgets are used for
actual cash control.

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 Float and its types

Float
•Float is defined as the difference between the firm’s/individual’s book balance
(book cash or ledger cash) and the balance on the bank’s record (bank cash or
collected bank cash) of an account. In other words float can be defined as
“Funds that have been sent by the payer but are not yet usable funds to the
payee". So, “Float” represents the net effect of cheques in the process of
collections.
• Float = Firm’s bank cash – Firm’s book cash
A positive float occurs when the firm’s bank cash is greater than its book cash.
A negative float occurs when the firm’s book cash is greater than its bank cash.

• Cheques written by the firm generate disbursement float, causing an

immediate decrease in book cash but no immediate change in bank cash.
• Cheques received by the firm represent collection float, which increase book
cash immediately but does not immediately change bank cash.
• So, the firm is helped by disbursement float and hurt by collection float.
• The difference of disbursement float and collection float is net float. 13
 Float and its types
• For example, assume that you go to the bank and open a checking account with
$500. You receive no interest on the $500 and pay no fee to have the account.
Now assume that you receive your electricity bill in the mail and that it is for
$100. You write a cheque for $100 and mail it to the utility company. At the time
you write the $100 cheque you also record the payment in your bank register.
Your bank register reflects the book value of the checking account. The cheque
will literally be "in the mail" for a day or two before it is received by the utility
company and may take another few more days before the company cashes it.

• This float can be managed. If you know that the bank will not learn about your
cheque for five days, you could take the $100 and invest it elsewhere for the
five days and then place it back into your checking account "just in time" to
cover the $100 check

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 Float and its types

Time Book Bank

Balance Balance
T=O (Make Deposit) $500 $500

T=1 (Write $100 cheque) $400 $500

T=2 (Bank receives $400 $400

cheque)

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 Float and its types

Float is calculated by subtracting the book balance from the bank

balance.
Float at Time 0: $500 - $500 = $0
Float at Time 1: $500 - $400 = $100
Float at Time 2: $400 - $400 = $0

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 Float and its types

Policy For Cash Being Held (float example)

•Here a firm already is holding the cash so the goal is to maximize the benefits from
holding it and wait to pay out the cash being held until the last possible moment.
•Extending the previous example. Assume that rather than investing $500 in a checking
account that does not pay any interest, you invest that $500 in liquid investments.
•Further assume that the bank believes you to be a low credit risk and allows you to
maintain a balance of $0 in your checking account.
•This allows you to write a $100 cheque to the electric company and then transfer
funds from your investment to the checking account in a "just in time" fashion. By
employing this JIT system you are able to draw interest on the entire $500 up until
you need the $100 to pay the utility company. Firms often have policies similar to
this one to allow them to maximize idle cash.

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 Float and its types
 Example: A cheque of $1000 is mailed from a customer on Monday,
September 1. Because of mail, processing and clearing delays, it is not
credited as available cash in the firm’s bank until the following Monday,
seven days later. The float for this cheque is:
Float = $1000 X 7 days = $7000

 Another cheque for $7000 is mailed on September 1. it is

available on the next day. The float for this cheque is:

Float = $7000 X 1day = $7000

 The measurement of float depends on the time lag and the
amount involved. The cost of float is an opportunity cost,
because the cash is unavailable for use during the time
cheques are tied up in the collection process.
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 Cash Management System

Collections Disbursements

Marketable securities
investment

Control through information reporting

= Funds Flow = Information Flow 19

 Speeding Up
Cash Receipts
Collections
 Expedite preparing and mailing the invoice
 Accelerate the mailing of payments from customers
 Reduce the time during which payments received by
the firm remain uncollected

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 Collection Float

Mail Processing Availability

Float Float Float

Deposit Float

Collection Float:
Float total time between the mailing
of the check by the customer and the availability
of cash to the receiving firm.
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 Mail Float

Customer Firm
mails check receives check

Mail Float:
Float time the check is in the
mail. Cheques are trapped in the postal
system. It is the part of collection float.

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 Processing Float

Firm Firm
receives check deposits check

Processing Float:
Float time it takes a company
to process the check internally. It is also a part
Of collection float

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 Availability Float

Firm Firm’s bank

deposits check account credited

Availability Float:
Float time required in clearing
the check through the banking system. It is also
A part of collection float.

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 Deposit Float

Processing Float Availability Float

Deposit Float:
Float time during which the check
received by the firm remains uncollected funds.
So, the deposit float has two aspects. The first
aspect is the processing float and second being
The availability float. 25
Earlier Billing
Accelerate preparation and mailing of
invoices
 computerized billing
 invoices included with shipment
 invoices are faxed
 advance payment requests
 preauthorized debits

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Preauthorized Payments
Preauthorized debit
The transfer of funds from a payor’s bank
account on a specified date to the payee’s
bank account; the transfer is initiated by the
payee with the payor’s advance
authorization.

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Lockbox System
Lockbox
A post office box maintained by a firm’s
bank that is used as a receiving point for
customer payments.

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 Lockbox Process
 Customers are instructed to mail their payments to the
lockbox location.
 Bank picks up payments several times daily from the
lockbox.
 Bank deposits payments in the customers account and
provides a deposit slip with a list of payments.
 Often the checks are first scanned and converted into digital
images. These images can then be transmitted to the
company or supplied on a CD-ROM.
 Company also receives the list and any additional mailed
items.

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Lockbox System
Advantage
Receive payments sooner which
reduces processing float.

Disadvantage
Cost of creating and maintaining a lockbox system.
Generally, not advantageous for small amount payments.

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Concentration Banking
Moving cash balances to
a central location:
 Improves control over inflows and outflows of corporate cash.
 Reduces idle cash balances to a minimum.
 Allows for more effective investments by pooling excess cash
balances.

Compensating Balance
Minimum account balance maintained by a firm to
compensate a bank for services provided, credit lines, or
loans.
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Concentration Services for
Transferring Funds
Automated Clearing House (ACH) Electronic transfer
An electronic version of check.
(1) Electronic check image .

(2) Cost is not significant .

Wire Transfer : A generic term for electronic funds transfer

using a two-way communications system,
Funds are available upon receipt of the wire transfer.
Much more expensive.

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 S-l-o-w-i-n-g D-o-w-n
Cash Payouts
 Control of Disbursements
 Payroll and Dividend
Disbursements
 Zero Balance Account (ZBA)
 Remote and Controlled Disbursing

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 Methods of Managing
Disbursements
Payroll and Dividend Disbursements
The firm attempts to determine when payroll and
dividend checks will be presented for collection.
 Many times a separate account is set up to handle each of
these types of disbursements.
 A distribution scheduled is projected based on past
experiences. Funds are deposited based on expected
needs.
 Minimizes excessive cash balances.

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 Percentage of Payroll
Checks Collected
100%
The firm may plan on
Payroll Collected

75% payroll checks being

presented in a similar
Percent of

50% pattern every pay period.

25%

0%
F M T W H F M and after
(Payday)
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 Methods of Managing
Disbursements
Zero Balance Account (ZBA):
A corporate current account in which a zero
balance is maintained. The account requires a
master (parent) account from which funds are
drawn to cover negative balances or to which
excess balances are sent.
 Eliminates the need to accurately
estimate each disbursement account.
 Only need to forecast overall cash needs.
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 Remote and
Controlled Disbursing
Controlled Disbursement -- A system in
which the firm directs checks to be drawn
on a bank (or branch bank) that is able to
give early or mid-morning notification of
the total dollar amount of checks that will
be presented against its account that day.
Late check presentments are minimal, which allows more
accurate predicting of disbursements on a day-to-day basis.

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Cash Conversion Cycle
 The length of time from the payment for
the purchase of raw materials to
manufacture a product until the collection
of accounts receivable associated with the
sale of the product.

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Cash Conversion Cycle

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Inventory Conversion Period
 The inventory conversion period is the
length of time from the purchase of
inventory to the time the sales are made
on credit.

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Receivables Collection Period
 The receivables collection period is the
average number of days it takes to collect
on accounts receivable.
 Equal to days sales outstanding (DSO)

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Payables Deferral Period
 The payables deferral period is the
average length of time between the
purchase of materials and labor and the
payment of cash for the same.

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Operating Cycle
 The time from the beginning of the
production process to the collection of
cash from the sale of the finished product.
 Operating Cycle = Inventory Conversion
Period + Receivables Collection Period

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Determining the Target Cash Balance
 Baumol Model
 Deterministicmodel.
 Future cash requirements and disbursements
are known with perfect certainty
 Miller-Orr Model
 Stochastic model.
 Daily cash flows vary according to a normal
probability distribution with known variance

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Costs of Holding Cash
Costs in dollars of
holding cash Trading costs increase when the firm
must sell securities to meet cash needs.
Total cost of holding cash

Opportunity
Costs
The investment income
foregone when holding cash.

Trading costs
C* Size of cash balance
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The Baumol Model
F = The fixed cost of selling securities to raise cash
T = The total amount of new cash needed
K = The opportunity cost of holding cash: this is the interest rate.
C = Size of each deposit

If we start with $C,

spend at a constant rate
each period and replace
C our cash with $C when
we run out of cash, our
average cash balance
C will be C .
2 2
The opportunity cost
of holding C is C  K
Time 2 2
1 2 3 52
The Baumol Model
F = The fixed cost of selling securities to raise cash
T = The total amount of new cash needed
K = The opportunity cost of holding cash: this is the interest rate.
C = Size of each deposit

As we transfer $C each
period we incur a trading
cost of F each period. If
C
we need T in total over the
planning period we will
C pay $F, T ÷ C times.
2 T
The trading cost is F
C

1 2 3 Time 53
The Baumol Model
C T
Total cost   K   F
2 C
C
Opportunity Costs  K
2

T
Trading costs F
C
C* Size of cash balance
The optimal cash balance is found where the opportunity
costs equal the trading costs
2T
C 
*
F 54
K
The Baumol Model
The optimal cash balance is found where the opportunity
costs equal the trading costs

Opportunity Costs = Trading Costs

C T
K  F
2 C
Multiply both sides by C

C2 T F
K T F C  2
2

2 K
2TF
C 
*

K
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 Limitations of Baumol model
1. The model assumes the firm has constant
disbursement rate. In practice disbursements can
be only partially managed, because due dates differ
and costs can not be predicted with certainty.
2. The model assumes there are no cash receipts
during the projected period. In fact, most firms
experience both cash inflows and outflows on a
daily basis.
3. No safety stock is allowed for. Firms will probably
want to hold a safety stock of cash designed to
reduce the possibility of cash shortage or cash-out.
However, to the extent that firms can sell
marketable securities or borrow in a short notice,
the need for safety stock is minimal.

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The Miller-Orr Model
 The firm allows its cash balance to wander randomly
between upper and lower control limits.

$ When the cash balance reaches the upper control limit H cash
is invested elsewhere to get us to the target cash balance Z.
H When the cash
balance reaches the
lower control limit,
L, investments are
sold to raise cash
Z to get us up to the
target cash
L balance.

Time 57
 The Miller-Orr Model
2
3 Fσ
Z*  3 L H  3Z  2 L
*
4K
 Given L, which is set by the firm, the Miller-Orr model solves for Z
and H.
where 2 = is the variance of net daily cash flows.
σ = is the standard deviation of the net cash flows
F = Fixed cost of converting securities into cash
K = annual opportunity cost of holding cash
LCL (L) = Lower control limit
UCL (H) = Upper control limit
Z = The amount of securities converted into cash when cash balance
hits the LCL.
• The average cash balance in the Miller-Orr model is

4Z *  L
Average cash balance 
3
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Implications of the Miller-Orr Model
 To use the Miller-Orr model, the manager must do four things:
1. Set the lower control limit for the cash balance.
2. Estimate the standard deviation of daily cash flows.
3. Determine the interest rate.
4. Estimate the trading costs of buying and selling
securities.

 The model clarifies the issues of cash management:

 The best return point, Z, is positively related to trading

costs, F, and negatively related to the interest rate K.
 Z and the average cash balance are positively related to
the variability of cash flows.
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End of the Chapter

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