Holding of cash to meet routine cash requirements to finance the transactions which a firm carries on in the ordinary course of business is known as
transaction motive.
Cash balances held in reserve for random and unforeseen fluctuations in cash flows are called as
earlier than expected 3. Unexpected slow down in collection of accounts receivable 4. Cancellation of some order for goods as the customer is not satisfied 5. Sharp increase in cost of raw materials
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 is known as speculative motive.
1. 2. 3.
It is done to take advantage of: An opportunity to purchase RMs at a reduced price on payment of immediate cash. Investment in securities Buying raw materials when decline in price is anticipated.
The minimum balance that every firm needs to have in its current account with a bank cannot be used by the bank for transaction purpose and thus becomes a sort of investment by the firm which is
called compensating
Balance is to be struck between holding too much cash and too little cash.
Short Costs: Expenses incurred as a result of shortfall in cash (a) Transaction cost (brokerage incurred in selling marketable securities)
(b) Borrowing costs (interest on loan etc.)
rating (refusal to sell, loss of image, higher bank charges on loans, stoppage of supplies, loss of image, demand for cash payment)
(e) Penalty rates
associated with operating cash mgt staff like salary, storage, handling of securities)
(unexpected delays in collection and disbursements, defaults and unexpected cash needs)
Factors that generate cash flows are mainly divided into two
Operating
Financial
point of time then appropriate means of overcoming the shortage or managing the surplus must be explored.
Shortage: convert marketable securities to cash Surplus: convert cash to marketable securities
Thus optimum cash balance must be found out which is a trade-off between risk and return of maintaining cash balance.
BAUMOLs model
Same as economic order quantity model of inventory
management.
cost (holding cost) of holding cash against the transaction cost of converting cash into marketable securities or viceversa.
C=
2 AF/O
BAUMOLS MODEL
TOTAL COST
COSTS
TRANSC. COST
CASH BALANCE
ASSUMPTIONS
Cash needs of the firm are known
for certainty Cash disbursements of the firm occurs uniformly over a period of time and is known with certainty. Opportunity cost and transaction cost are known and remain constant throughout.
CRITICISMS
The model assumes a constant rate of use of cash
Miller-Orr model
This model overcomes the demerits of Baumols model of
L.
H is the upper limit beyond which cash balance need not be allowed to go. L is the lower limit below which cash level is not
allowed to reduce.
Cash balance should be allowed to move within
these limits.
If cash balance reaches H a part of cash should be invested in marketable securities so that cash balance comes down to the predetermined level called the RETURN LEVEL- R.
If cash balance reaches L sufficient marketable securities should be sold to realize cash so that cash balance is restored to the RETURN LEVEL R.
The spread between the lower and the upper limit computed by the model is that which minimizes the sum of transaction cost and the opportunity cost.
1. 2.
variability, transaction cost and the interest rate. The spread is added to the lower cash limit in order to find out the upper cash limit of the firm.
1/3
interest rate/day
Upper Limit= Lower Limit +3Z Return point = lower limit + Z Average cash balance = Lower Limit +4/3 Z Variance of cash flows= (standard deviation)2
cash flows and actual cash flows and to achieve this cash management efficiency will have to be improved through
1.
possible
Customers should be encouraged to make the payment as soon as possible 2. Payments from customers should be converted into cash without any delay. Prompt payment by customers 1. Prompt billing and invoicing 2. Offering cash discounts Early conversion of payments into cash 1. Prompt encashment (there is a time lag between the time a cheque is prepared and mailed by a customer and finally it comes to the firm)
1.
Deposit Float
Within this time there are 3 steps involved a) Transit or mailing time (Postal Delay) b) Processing time( Lethargy) c) Collection Time(Bank Float)
Deposit Float is defined as the sum of cheques written by customers that are not yet usable by the firm. However through decentralized collection the deposit float may be reduced.
Slowing Disbursements
Avoidance of early payments Centralized disbursements
encashment analysis
Accruals