Copyright © 2015 by McGraw Hill Education (India) Private Limited

Chapter 24
CASH AND LIQUIDITY
MANAGEMENT

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 OUTLINE
• Motives for Holding Cash
• Cash Budgeting
• Long-term Cash Forecasting
• Reports for Control
• Cash Collection and Disbursement
• Optimal Cash Balance
• Investment of Surplus Funds
• Cash Management Models

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 MOTIVES FOR HOLDING CASH

Keynes identified three possible motives for holding cash :

• Transaction motive

• Precautionary motive

• Speculative motive

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 CASH BUDGET
The principal method of cash budgeting is the receipts and disbursements method.
Under this method, the cash forecast shows the timing and magnitude of cash receipts
and disbursements over the forecast period.
Illustration
The following information about Beta Company is given:
• The estimated sales for the period January 20X1 through June 20X1 are as
follows: Rs.100,000 a month from January through March and Rs.120,000 a
month from April through June.
• The sales for November and December of the previous year have been
Rs.100,000 each.
• Cash and credit sales are expected to be 20 percent and 80 percent respectively.
• The receivables from credit sales are expected to be collected as follows: 50
percent after one month and the balance 50 percent after two months.
• Other anticipated receipts are: Rs.5,000 from the sale of a machine in March and
Rs.2000 interest on securities in June.

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 CASH BUDGETING

January February March April May June

1. Sales 100,000 100,000 100,000 120,000 120,000 120,000
2. Credit sales 80,000 80,000 80,000 96,000 96,000 96,000
3. Collection of
accounts
receivables 80,000 80,000 80,000 80,000 88,000 96,000
4. Cash sales 20,000 20,000 20,000 24,000 24,000 24,000
5. Receipt from
machine sale 5,000
6. Interest 2,000
Total cash
receipts 100,000 100,000 105,000 104,000 112,000 122,000
(3+4+5+6)

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 CASH BUDGETING
Relevant information for cash payments
· Beta Company plans to purchase materials worth Rs.40,000 in January and
February and materials worth Rs.48,000 each month from March through
June. Payments will be made a month after the purchase
· A payment of Rs.40000 will be made in January for purchases in the previous
December
· Miscellaneous cash purchases of Rs.2000 per month are planned from January
through June
· Wage payments will be Rs.15000 per month, January through June
· Payments for manufacturing expenses will be Rs.20,000 per month and for
general administrative expenses will be Rs.10,000 per month, January through
June
· Dividend payment of Rs.20,000 and a tax payment of Rs.20,000 are planned for
June
· A machine will be bought in cash for Rs. 50,000 in March

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 CASH BUDGETING
January February March April May June
1. Material
purchases 40,000 40,000 48,000 48,000 48,000 48,000
2. Credit material
purchases 40,000 40,000 48,000 48,000 48,000 48,000
3. Payment of 40,000 40,000 40,000 48,000 48,000
48,000
accounts
payable
4. Miscellaneous 2,000 2,000 2,000 2,000 2,000 2,000
cash purchases
5. Wages 15,000 15,000 15,000 15,000 15,000 15,000
6. Manufacturing
exp. 20,000 20,000 20,000 20,000 20,000 20,000
7. General admn.
expense 10,000 10,000 10,000 10,000 10,000 10,000
8. Dividend - - - - - 20,000
9. Tax - - - - -
20,000
10. Capital - - 50,000 - - -
expenditure
Total payments
135,000 87,000 87,000 137,000 95,000 95,000
(3+4+5+6+7+8+9+10)
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 CASH BUDGETING
Assuming that the cash balance on 1st January is Rs.22,000 and the minimum cash balance
required by the firm is Rs.20,000, the summary cash forecast is given below.
January February March April May June
1. Opening cash
balance Rs.22,000
2. Receipts 100,000 100,000 105,000 104,000 112,000 122,000
3. Payments 87,000 87,000 137,000 95,000 95,000
135,000
4. Net cash flow (2 –3) 13,000 13,000 (32,000) 9,000 17,000 (13,000)
5. Cumulative net
cash flow 13,000 26,000 (6,000) 3,000 20,000 7,000
6. Opening cash
balance +
Cumulative net flow (1 + 5) 35,000 48,000 16,000 25,000 42,000 29,000
7. Minimum cash balance
required 20,000 20,000 20,000 20,000 20,000 20,000
8. Surplus or deficit in 15,000 28,000 (4,000) 5,000 22,000 9,000
relation to the minimum
cash balance required
(6 – 7)

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 LONG-TERM CASH FORECASTING
Adjusted net income method is generally used for long-term cash
forecasting.
20 X 0 20 X 1 20 X 2 20 X 3 20 X 4
Source
Net income after taxes
Non-cash charges
(Depreciation, amortisation,
etc.)
Increase in borrowings
Sale of equity shares
Miscellaneous
Uses
Capital expenditures
Increase in current assets
Repayment of borrowings
Dividend payment
Miscellaneous
Surplus/ Deficit
Opening cash balance
Closing cash balance
 REPORTS FOR CONTROL

• Daily Cash Report

• Daily Treasury Report

• Monthly Cash Report

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 CASH COLLECTION AND DISBURSEMENT

• Float

• Speeding up Collections

• Delaying Payments

• EDI : Will the Float Disappear

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 FLOAT

• The cash balance shown by a firm on its books is called

the book, or ledger, balance whereas the balance shown
in its bank account is called the available, or collected,
balance. The difference between the available balance
and the ledger balance is referred to as float.

• There are two kinds of float viz., disbursement float and

payment float

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 OPTIMAL CASH BALANCE

Total costs

Opportunity cost

Costs

•
Transaction cost

C* Cash balance

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 INVESTMENT OF SURPLUS FUNDS

It may be useful to divide a firm’s short-term investment

portfolio into three segments:

• Ready cash segment

• Controllable cash segment

• Free cash segment

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 CRITERIA FOR EVALUATING
INVESTMENT OPTIONS

• Safety

• Liquidity

• Yield

• Maturity

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 INVESTMENT OPTIONS
• Fixed deposits with banks
• Treasury bills
• Mutual fund schemes
• Money market schemes
• Commercial paper
• Certificates of deposit
• Inter-corporate deposits
• Ready forwards
• Bill discounting

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 ELEMENTS OF CASH AND LIQUIDITY MANAGEMENT

In recent years the importance of cash and liquidity

management has increased dramatically. Cash management
comprises of five basic elements.
1. Collection The firm must accelerate the receipts into
available funds.
2. Disbursement The firm must control the release and timing
of funds.
3. Concentration The firm must inexpensively mobilise funds
from outlying banks to a single location for their efficient use.
4. Investment The firm must maximise yield within acceptable
limits of risk and maturity.
5. Information and Control The firm must develop reliable
short term cash forecasts and obtain accurate, timely data on
bank balances, bank deposits, and so on.
 CASH MANAGEMENT MODELS

Several cash management models have addressed this issue of

split between marketable securities and cash holdings. Two
such models are :

• Baumol model

• Miller and Orr model

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 BAUMOL MODEL

2bT
C=
I

where: C = amount of marketable securities converted into cash

per order

I = interest rate per planning period on investment in

marketable securities.

T = Projected cash requirements during the planning

period

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 MILLER AND ORR MODEL
3b 2
RP = 3 + LL
4I
UL = 3RP – 2LL
where: RP = return point
b = fixed cost per order for converting marketable
securities into cash.
I = daily interest rate earned on marketable securities
 2 = variance of daily changes in the expected cash balance
LL = the lower control limit
UL = the upper control limit

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 SUMMING UP
• There are three possible motives for holding cash, viz., transaction
motive, precautionary motive, and speculative motive.
• The principal method of short-term cash forecasting is the receipts
and payment method.
• The method generally used for long-term forecasting is the adjusted
income method.
• To enhance the efficiency of cash management collections and
disbursements must be properly monitored.
• A variety of options are there for investing surplus funds available
for short periods.
• William Baumol has proposed a model which applies the EOQ
concept to determine the cash conversion size.
• Expanding on the Baumol model, Miller and Orr consider a
stochastic generating process for periodic changes in cash balance.

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