Chapter 27

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 1. Sales 2. Credit sales 3. Collection of accounts receivables 4. Cash sales 5. Receipt from machine sale 6. Interest Total cash receipts 100,000 80,000 February 100,000 80,000 March April May June

100,000 120,000 120,000 120,000 80,000 96,000 96,000 96,000

80,000 20,000

80,000 20,000

80,000 20,000 5,000

80,000 24,000

88,000 96,000 24,000 24,000

2,000 100,000 100,000 105,000 104,000 112,000 122,000

(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
1. Material purchases 2. Credit material purchases 3. Payment of accounts payable 4. Miscellaneous cash purchases 5. Wages 6. Manufacturing exp. 7. General admn. expense 8. Dividend 9. Tax 10. Capital expenditure Total payments (3+4+5+6+7+8+9+10) 40,000

February
40,000

March
48,000

April
48,000

May

June

48,000 48,000

40,000 40,000
2,000

40,000 40,000
2,000

48,000 40,000
2,000

48,000 48,000
2,000

48,000 48,000 48,000 48,000

2,000 2,000

15,000
20,000 10,000 87,000

15,000
20,000 10,000 87,000

15,000
20,000 10,000 50,000 137,000

15,000
20,000 10,000 95,000

15,000
20,000 10,000 -

15,000
20,000 10,000 20,000 20,000 -

95,000 135,000

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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 1. Opening cash balance 2. Receipts 3. Payments 4. Net cash flow (2 3) 5. Cumulative net cash flow 6. Opening cash balance + Cumulative net flow (1 + 5) 7. Minimum cash balance required 8. Surplus or deficit in relation to the minimum cash balance required (6 7) February March April May June

Rs.22,000
100,000 87,000 13,000 13,000 100,000 87,000 13,000 26,000 105,000 104,000 112,000 122,000 137,000 (32,000) (6,000) 95,000 9,000 3,000 95,000 135,000 17,000 (13,000) 20,000 7,000

35,000 20,000 15,000

48,000 20,000 28,000

16,000 20,000 (4,000)

25,000 20,000 5,000

42,000 20,000 22,000

29,000 20,000 9,000

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LONG-TERM CASH FORECASTING

Adjusted net income method is generally used for long-term cash forecasting.
20 X 0 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 20 X 1 20 X 2 20 X 3 20 X 4

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 firms 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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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 4I + LL

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.
Centre for Financial Management , Bangalore