Cash management is one of the key areas of working capital management. Apart from the fact that it is the most liquid current asset, cash is the common denominator to which all current assets can be reduced because the other major liquid assets, that is, receivables and inventory get eventually converted into cash. This underlines the significance of cash management.MOTIVES FOR HOLDING CASH:
The term ‘cash’ with reference to cash management is used in two senses. In a narrow sense, it is used broadly to cover currency and generally accepted equivalents of cash, such as cheques, drafts and demand deposits in banks. The broad view of cash also includes near-cash assets, such as marketable securities and time deposits in banks. The main characteristics of these are that they can be readily sold and converted into cash. They serve as a reserve pool of liquidity that provides cash quickly when needed. They also provide a short term investment outlet for excess cash and are also useful for meeting planned outflow of funds. Here, the term cash management is employed in broader sense. Irrespective of the form in which it is held, a distinguishing feature of cash, as an asset, is that it has no earning power. There are four primary motives for maintaining cash balances –
1) Transaction motive
2) Precautionary motive
3) Speculative motive
4) Compensating motive
1) Transaction motive:
An important reason for maintaining cash balances is the transaction motive. This refers to the holding of cash to meet routine cash requirements to finance the transactions which a firm carries on in the ordinary course of business.
A firm enters into a variety of transactions to accomplish its objectives which have to be paid for in the form of cash. For example, cash payments have to be made for purchases, wages, operating expenses, financial charges like interest, taxes, dividends and so on. Similarly, there is a regular inflow of cash to the firm from sales operations, returns on outside investments and so on. These receipts and payments constitute a continuous two-way flow of cash. But the inflows (receipts) and outflows (disbursements) do not perfectly coincide or synchronise. At times, receipts exceed outflows while, at other times, payments exceed inflows. To ensure that the firm can meet its obligations when payments become due in a situation in which disbursements are in excess of the current receipts, it must have adequate cash balance. The requirements of cash balances to meet routine cash needs is known as the transaction motive and such motive refers to the holding of cash to meet anticipated obligations whose timing is not perfectly synchronized with cash receipts.
Of the receipts of cash and its disbursements could exactly coincide in the normal course of operations, a firm would not need cash for transaction purposes. Although a major part of transaction balances are held in cash, a part may also be in such marketable securities whose maturity conforms to the timing of the anticipated payments, such as payment of taxes, dividends and so on.
2) Precautionary motive:
In addition to the non-synchronisation of anticipated cash inflows and outflows in the ordinary course of business, a firm may have to pay cash for purposes which cannot be predicted or anticipated. The unexpected cash needs at short notice may be the result of:
- Floods, strikes and failure of important customers
- Bills may be presented for settlement earlier than expected
- Unexpected slow down in collection of accounts receivable
- Cancellation of some order for goods as the customer is not satisfied
- Sharp increase in cost of raw materials
The cash balances held in reserve for such random and unforeseen fluctuations in cash flows are called as precautionary balances. In other words, precautionary motive of holding cash implies the need to hold cash to meet unpredictable contingencies. Thus, precautionary cash balance serves to provide a cushion to meet unexpected contingencies. The more unpredictable are the cash flows, the larger is the need for such balances.
Another factor which has a bearing on the level of such cash balances is the availability of short-term credit. If a firm can borrow at short notice to pay for unforeseen obligations, it will need to maintain a relatively small balance and vice versa.
Such cash balances are usually held in the form of marketable securities so that they earn a return.
3) Speculative motive:
It refers to the desire of a firm to take advantage of opportunities which present themselves at unexpected moments and which are typically outside the normal course of business. While the precautionary motive is defensive in nature in that firms must make provisions to tide over unexpected contingencies, the speculative motive represents a positive and aggressive approach. Firms aim to exploit profitable opportunities and keep cash in reserve to do so. The speculative motive helps to take advantage of:
- An opportunity to purchase raw materials at a reduced price on payment of immediate cash
- A chance to speculate on interest rate movements by buying securities when interest rates are expected to decline
- Delay purchases of raw materials on the anticipation of decline in prices
- Make purchase at favourable prices
4) Compensating motive:
Yet another motive to hold cash balances is to compensate banks for providing certain services and loans.
Banks provide a variety of services to business firms, such as clearance of cheque, supply of credit information, transfer of funds and so on. While for some of these services banks charge a commission or fee, for others they seek indirect compensation. Usually clients are required to maintain a minimum balance of cash at the bank. Since this balance cannot be utilized by the firms for transaction purposes, the banks themselves can use the amount to earn a return. Such balances are compensating balances.
Compensating balances are also required by some loan agreements between a bank and its customers. During periods when the supply of credit is restricted and interest rates are rising, banks require a borrower to maintain a minimum balance in his account as a condition precedent to the grant of loan. This is presumably to ‘compensate’ the bank for a rise in the interest rate during the period when the loan will be pending.
Of the four motives of holding cash balances, the two most important are the transactions motive and the compensation motive. Business firms normally do not speculate and need not have speculative balances. The requirement of precautionary balances can be met out of short-term borrowings.
OBJECTIVES OF CASH MANAGEMENT
The basic objectives of cash management are two-fold :–
a) To meet the cash disbursement needs (payment schedule)
b) To minimize funds committed to cash balances
These are conflicting and mutually contradictory and the task of cash management is to reconcile them.
Meeting Payments Schedule
In the normal course of business, firms have to make payments of cash on a continuous and regular basis to suppliers of goods, employees and so on. At the same time, there is a constant inflow of cash through collections from debtors. Cash is, therefore, aptly described as a the ‘oil to lubricate the ever-turning wheels of business: without it the process grinds to a stop. A basic objective of cash management is to meet the payment, that is, to have sufficient cash to meet the cash disbursement needs of a firm.
The importance of sufficient cash to meet the payment schedule can hardly be overemphasized. The advantages of adequate cash are:
i) It prevents insolvency or bankruptcy arising out of the inability of a firm to meet its obligations
ii) The relationship with the bank is not strained
iii) It helps in fostering good relations with trade creditors and suppliers of raw materials, as prompt payment may help their own cash management
iv) A cash discount can be availed of if payment is made within due date
v) It leads to a strong credit rating which enables the firm to purchase goods on favourable terms and to maintain its line of credit with banks and other sources of credit
vi) To take advantage of favourable business opportunities that may be available periodically
vii) The firm can meet unanticipated cash expenditure with a minimum of strain during emergencies, such as strikes, fires or a new marketing campaign by competitors
Keeping large cash balances, however, implies a high cost. The advantage of prompt payment of cash can well be realized by sufficient and not excessive cash.
Minimizing Funds Committed To Cash Balances
The second objective of cash management is to minimize cash balances. In minimizing the cash balances, two conflicting aspects have to be reconciled. A high level of cash balances will, as shown above, ensure prompt payment together with all the advantages. But it also implies that large funds will remain idle, as cash is a non-earning asset and the firm will have to forego profits. A low level of cash balances, on the other hand, may mean failure to meet the payment schedule. The aim of cash management, therefore, should be to have an optimal amount of cash balances. Keeping in view these conflicting aspects of cash management, we propose to discuss the planning/determination of the need for cash balances. There are two aspects involved in cash planning: first, an examination of those factors which have a bearing on the firm’s required cash balances; second, a review of the approaches to achieve optimum cash balances.
FACTORS DETERMINING CASH NEEDS
The factors that determine the required cash balances are:
1) Synchronization of cash flows
2) Short costs
3) Excess cash balance
4) Procurement and management and
5) Uncertainty
Synchronization Of Cash Flows
The need for maintaining cash balances arises from the non-synchronization of the inflows and outflows of cash: if the receipts and payments of cash perfectly coincide or balance each other, there would be no need for cash balances. The first consideration in determining the cash need is, therefore, the extent of non- synchronization of cash receipts and disbursements. For this purpose, the inflows and outflows have to be forecast over a period of time, depending upon the planning horizon which is typically a one-year period with each of the 12 months being a sub period. The technique adopted is a cash budget. A properly prepared budget will pinpoint the months/periods when the firm will have an excess or a shortage of cash.
Short Costs
Another general factor to be considered in determining cash needs is the cost associated with a shortfall in the cash needs. The cash forecast presented in the cash budget would reveal periods of cash shortages. In addition, there may be some unexpected shortfall. Every shortage of cash- whether expected or unexpected- involves a cost ‘depending upon the severity, duration and frequency of the shortfall and how the shortage is covered. Expenses incurred as a result of shortfall are called short costs. Included in the short costs are the following:
1) Transaction costs associated with raising cash to tide over the shortage. This is usually the brokerage incurred in relation to the sale of some short-term near-cash assets such as marketable securities.
2) Borrowing costs associated with borrowing to cover the shortage. These include items such as interest on loan, commitment charges and other expenses relating to the loan.
3) Loss of cash-discount, that is, a substantial loss because of a temporary shortage of cash.
4) Cost associated with deterioration of the credit rating which is reflected in higher bank charges on loans, stoppage of supplies, demands for cash payment, refusal to sell, loss of image and the attendant decline in sales and profits..
5) Penalty rates by banks to meet a shortfall in compensating balances.
Excess Cash Balance Costs
The cost of having excessively large cash balances is known as the excess cash balance cost. If large funds are idle, the implication is that the firm has missed opportunities to invest those funds and have thereby lost interest which it would otherwise have earned. This loss of interest is primarily the excess cost.
Procurement and Management
These are the costs associated with establishing and operating cash management staff and activities. They are generally fixed and are mainly accounted for by salary, storage, handling of securities, and so on.
Uncertainty and Cash Management
The impact of uncertainty on cash management is also relevant as cash flows cannot be predicted with complete accuracy. The first requirement is a precautionary cushion to cope with irregularities in cash flows, unexpected delays in collection and disbursements, defaults and unexpected cash needs.
The impact of uncertainty on cash management can, however, be mitigated through
1) Improved forecasting of tax payments, capital expenditure, dividends, and so on; and
2) Increased ability to borrow through overdraft facility.
DETERMINING CASH NEED
After the examination of the pertinent considerations and cost that determine cash needs, the next aspect relates to the determination of cash needs.
There are two approaches to derive an optimal cash balance, namely (a) minimizing cost cash models and (b) cash budget
Cash management/conversion models
While it is true that financial managers need not necessarily follow cash management models exactly but a familiarity with them provides an insight into the normative framework as to how cash management should be conducted. One the important analytical model for cash management is the Baumol Model.
Baumol Model
The Baumol model of cash management is one of many by which cash is managed by companies. It is extensively used and highly useful for the purpose of cash management.
Use of Baumol Model
The Baumol model enables companies to find out their desirable level of cash balance under certainty.
Relevance
At present many companies make an effort to reduce the costs incurred by owning cash. They also strive to spend less money on changing marketable securities to cash. The Baumol model of cash management is useful in this regard.
Assumptions
There are certain assumptions or ideas that are critical with respect to the Baumol model of cash management:
- The particular company should be able to change the securities that they own into cash, keeping the cost of transaction the same. Under normal circumstances, all such deals have variable costs and fixed costs.
- The company is capable of predicting its cash necessities. They should be able to do this with a level of certainty. The company should also get a fixed amount of money. They should be getting this money at regular intervals.
- The company is aware of the opportunity cost required for holding cash. It should stay the same for a considerable length of time.
- The company should be making its cash payments at a consistent rate over a certain period of time. In other words, the rate of cash outflow should be regular.
Equational Representations in Baumol Model of Cash Management:
- Holding Cost = k(C/2)
- Total Cost = k(C/2) + c(T/C)
- Transaction Cost = c(T/C)
Illustration
The ABC Ltd requires Rs. 30 lakhs in cash to meet its transaction needs during the next three month cash planning period. It holds marketable securities of an equal amount. The annual yield on these marketable securities is 20%. The conversion of these securities into cash entails a fixed cost of cash per order. Assuming ABC Ltd can sell its marketable securities in any of the five lot size: Rs 1,50,000; Rs 3,00,000; Rs 6,00,000; Rs 7,50,000; Rs 15,00,000; prepare a table indicating the economic lot size using numerical analysis.
Solution:
Formula to calculate optimal conversion amount:
C = 2bT
i
Where C=optimal conversion amount/amount of marketable securities converted in to cash per order;
b= cost of conversion into cash per lot/transaction;
T= projected cash requirement during the planning period;
i = interest rate earned per planning period on investment in marketable securities.
CASH BUDGET
Cash budget : Management Tool
A firm is well advised to hold adequate cash balances but should avoid excessive balances. The firm has, therefore, to assess its need for cash properly. The cash budget is probably the most important toll in cash management. It is a device to help a firm to plan and control the use of cash. It is a statement showing the estimated cash inflows and cash outflows over the planning horizon. In other words, the net cash position (surplus or deficiency) of a firm as it moves from one budgeting subperiod to another is highlighted by the cash budget.
The various purpose of cash budgets are: (i) to coordinate the timings of cash needs. It identifies the periods when there might be a shortage of cash or an abnormally large cash requirement; (ii) it pinpoints the period when there is likely to be excess cash; (iii) it enables a firm which has sufficient cash to take advantage of cash discounts on its accounts payable , to pay obligations when due , to formulate dividend policy, to plan financing of capital expansion and to help unify the production schedule during the year so that the firm can smooth out costly seasonal fluctuations , finally, (iv) it helps to arrange needed funds on the most favourable terms and prevents the accumulation of excess funds. With adequate time to study his needs, the finance manager can select the best alternative. In contrast, a firm which does not budget its cash requirements, may suddenly find itself short of funds. With pressing needs and little time to explore alternative avenues of financing, the management would be forced to accept the best terms offered in a difficult situation. These terms will not be as favourable, since the lack of planning indicates to the lender, the is no organizational deficiency. The firm, therefore, represents a higher risk.
Elements/Preparation of Cash Budget
Thus, the principal aim of the cash budget, as a tool to predict cash flows over a given period of time, is to ascertain whether at any point of time there is likely to be an excess or shortage of cash. The preparation of a cash budget involves various steps.
These may be described as the elements of the cash budgeting system.
The first element of a cash budget is the selection of the period of time to be covered by the budget. It is referred to as the planning horizon. The planning horizon means the time span and the sub periods within that time span over which the cash flows are to be projected. There is no fixed rule. The coverage of a cash budget will differ from firm to firm depending upon its nature and the degree of accuracy with which the estimates can be made. As a general rule , the period selected should be neither too long too short. If it is too long, it is likely that the estimates will just beyond the period cannot be accounted for and the work associated with the preparation of the budget becomes excessive.
The planning horizon of a cash budget should be determined in the light of the circumstances and requirements of a particular case. For instance, if the flows are expected to be stable and dependable, such a firm may prepare a cash budget covering a long period, say, a year and divide it into quarterly intervals. In the case of a firm whose flows are uncertain, a quarterly budget, divided into monthly intervals, may be appropriate. Where flows are affected by seasonal variations, monthly budgets, sub – divided, on a weekly or even a daily basis, may be necessary. If the flows are subject to extreme fluctuations, even a daily budget may be called for. The idea behind subdividing the budgeting period into smaller intervals is to highlight the movement of cash from one sub period to another. The subdivision will provide information on the fluctuation in the cash reservoir level during the time span covered by the budget.
The second element of the cash budget is the selection of the factors that have a bearing on cash flows. The items included in the cash budget are only cash items; non-cash items such as depreciation and amortization are excluded. The factors that generate cash flows are generally divided, for purposes of the construction of cash budget, into two broad categories; (a) operating, and (b) financial. These two–fold classifications of cash budget items are based on their nature. While the former category includes cash flows generated by the operations of the firms and are known as operating cash flows, the latter consists of financial cash flows.
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