CASH MANAGEMENT

CASH MANAGEMENT

LEARNING OBJECTIVES
Give the nature of cash.
List out the motives for holding cash.
Discuss the objectives of cash management.
Narrate the aspects of cash management.
Give the meaning of cash budget, procedure, purpose of cash budget.
Discuss the types of cash forecasting.
Know the strategies for accelerating cash inflows, and slowing down payments.
Determine optimum cash balance.
Explain the models of cash management.
Identify the investment avenues for investing surplus cash.
Analyse the performance of cash management

Cash Management and Nature of Cash

Cash Management: It involves in minimizing idle cash without impairing liquidity of a firm
Nature of Cash:
Narrow sense
Broader sense
Cash Management Strategies
include budgeting,
keeping financial records,
maximizing the interest earned on checking and savings accounts, and
regularly preparing financial statements, such as net worth and cash flow.
One of the soundest pieces of financial advice is to spend less than you earn.
After you track your income and expenses, following a budget that is adjusted to your
individual situation and goals is an excellent strategy to plan your spending.
Motives for holding Cash
Transaction motive
Precautionary motive
Speculative motive
Liquid Asset Management
CASH- motives for holding cash:
Transactions: to meet cash needs that arise from doing business.
Precautionary: having cash on hand for unexpected needs.

 Speculative: to take advantage of potential profit-making situations.

Four Facets of Cash Management

Cash planning
Managing the cash flows
Determining optimum cash level
Investing surplus cash
Cash Planning
Cash planning is a technique to plan and control the use of cash.
Cash Forecasting and Budgeting
Cash budget is the most significant device to plan for and control cash receipts and payments.
Cash forecasts are needed to prepare cash budgets.
Short term Cash Forecasts
The important functions of short-term cash forecasts
To determine operating cash requirements
To anticipate short-term financing
To manage investment of surplus cash.
Short-term Forecasting Methods
The receipt and disbursements method
The adjusted net income method.
Receipts and Disbursement Method
The virtues of the receipt and payment methods are:
It gives a complete picture of all the items of expected cash flows.
It is a sound tool of managing daily cash operations.
This method, however, suffers from the following limitations:
Its reliability is reduced because of the uncertainty of cash forecasts. For example, collections
may be delayed, or unanticipated demands may cause large disbursements.
It fails to highlight the significant movements in the working capital items.
Adjusted Net Income Method
The benefits of the adjusted net income method are:
It highlights the movements in the working capital items, and thus helps to keep a control on a

firms working capital.

It helps in anticipating a firms financial requirements.
The major limitation of this method is:
It fails to trace cash flows, and therefore, its utility in controlling daily cash operations is
limited.
Long Term Cash forecasts
The major uses of the long-term cash forecasts are:
It indicates as companys future financial needs, especially for its working capital
requirements.
It helps to evaluate proposed capital projects. It pinpoints the cash required to finance these
projects as well as the cash to be generated by the company to support them.
It helps to improve corporate planning. Long-term cash forecasts compel each division to plan
for future and to formulate projects carefully.
Cash Collection and Disbursement
Accelerating Cash Collections
Decentralised Collections
Lock-box System
Cash cycle
The process of tracing a firms operations that result in cash flows is called Cash Cycle.
It is the time gap between the actual cash receipts and actual cash payments.
There is a movement of cash during this conversion period as follows:
Cash Raw Materials Work in process- Finished Goods Receivables - Cash.
Cash Conversion Cycle
Cash cycle = Operating Cycle - Time take to pay Suppliers
Components of Cash Cycle
Average payment period = Accounts payable / Purchases per day. It is the average length of
time for which the accounts payable are outstanding.
Disbursement time: The time gap between the date on which the check is mailed to the date on
which the account is received.
Average inventory period: Inventory / Cost of goods sold per day. It is the average length of
time for which the goods are held in inventory.

 Average collection period: Accounts receivables / Credit sales per day. It is the average length
of time for which the Account Receivables are outstanding .
The collection period
Customer payment period : The length of time the customer takes to mail the check to pay for
the goods .
Mail time : The length of time it takes for the firm to receive the check.
Processing time: The time it takes from receipt of check until the firm updates its records and
delivers check to the bank.
Availability time: The interval between deposit of check and actually having cash in the
account .
Average cash cycle period: Average Collection period + Average inventory period - Average
payment period.
Float
It is the money in the process of being collected. It is expressed in amount. There are two types:
Collection float: The money in the process of being received by the firm from the customers. It
starts when the customer initiates payment and ends when cash is available.
There are three components: (i) Mail float (ii) Processing float (iii) Availability float.
Disbursement float: The money in the process of being paid by the firm to its employees
,suppliers and other obligations. It is the money held up in the time gap between the moment the
firm initiates payment and the moment the cash leaves the firms account.
The balance sheet cash balance = Available deposit balance at bank +currency +check
deposited but not yet available +check in hand but not yet deposited checks written but not yet
presented.
10 Cash Flow Rules
Never Run Out of Cash.
Cash Is King
Know the Cash Balance Right Now.
Do Today's Work Today.
Either You Do the Work or Have Someone Else Do It.
Don't Manage From the Bank Balance
Know What You Expect the Cash Balance to be Six Months From Now
Cash Flow Problems Don't "Just Happen.
You Absolutely, Positively Must Have Cash Flow Projections.

 Eliminate Your Cash Flow Worries So You Are Free to Do What You Do Best - Take Care of
Customers and Make More Money.
How much cash should a organization keep on hand?
Enough cash to make payments when needed. (transactions motive)
(Daily or Weekly Cash Budget helpful)
Additional cash may be held for unexpected requirements. (precautionary motive)
The size of the minimum cash balance depends on:
How quickly and cheaply a organization can raise cash when needed.
How accurately managers can predict cash requirements.
(Cash Budget helpful)
How much precautionary cash the managers need for emergencies.
The organizations maximum cash
balance depends on:
Available (short-term) investment opportunities
e.g. money market funds, CDs, commercial paper
Expected return on investment opportunities.
e.g. If expected returns are high, organizations should be quick to invest excess cash
Transaction cost of withdrawing cash and making an investment
Demand for Cash for daily transactions
(Cash Budget helpful)
Managing of cash flows into and out of the firm,
cash flows within the firm, and cash balances held by the firm at a point of time by financing
deficit or investing surplus cash
Cash Management
Managing Cash Inflow
Reducing Float can speed up cash receipts.
Mail Float: length of time from the moment a customer mails a check until the firm begins to
process it.
Processing Float: the time required by a firm to process a check before it can be deposited in a
bank.

Managing Cash Inflow

Reducing Float can speed up cash receipts.
Transit float: time required for a check to clear through the banking system and become usable
funds.

Disbursing float: occurs because funds are available in a firms bank account until its payment
check has cleared through the banking system.
Cash Management
Managing Cash Inflow
Lockbox System
Instead of mailing checks to the firm, customers mail checks to a nearby P.O. Box. A commercial
bank collects and deposits the checks.
This reduces mail float, processing float and transit float.
Lockbox System benefits:
Increased working cash - reduces time required to convert receivables to cash.
Elimination of clerical functions - bank handles receiving, endorsing, totaling and depositing.
Early knowledge of dishonored checks - firm learns of customers bad checks faster.
Preauthorized Checks (PACs)
Arrangement that allows firms to create checks to collect payments directly from customer
accounts.
This reduces mail float and processing float.
PAC System benefits:
Highly predictable cash flows.
Reduced expenses - eliminates billing and postage costs; reduces clerical processing costs.
Customer preference - eliminates regular billing for customers.
Increased working cash - dramatically reduces mail float and processing float.
Depository Transfer Checks (DTCs)
Moves cash from local banks to concentration bank accounts.
Firms avoid having idle cash in multiple banks in different regions of the country.
DTC System benefits:
Lower levels of excess cash Reduced expenses - eliminates billing and postage costs; reduces clerical processing costs.
Customer preference - eliminates regular billing for customers.
Increased working cash - dramatically reduces mail float and processing float.
Eliminates transit float.
Cash Management

 Zero Balance Accounts (ZBAs)

Different divisions of a firm may write checks from their own ZBA.
Division accounts then have negative balances.
Cash is transferred daily from the firms master account to restore the zero balance.
Allows more control over cash outflows.
Payable-Through Drafts (PTDs)
Allows the firm to examine checks written by the firms regional units.
Checks are passed on to the firm, which can stop payment if necessary.
Remote Disbursing
Firm writes checks on a bank in a distant town.
This extends disbursing float.
(Discouraged by the Federal Reserve System by US)
Marketable Securities
Considerations
Financial Risk - uncertainty of expected returns due to changes in issuers ability to pay.
Interest rate risk - uncertainty of expected returns due to changes in interest rates.
Liquidity - ability to transform securities into cash.
Taxability - Taxability of interest income and capital gains.
Yield - Influenced by the previous 4 considerations.
Cash Budget and Its Purpose
Cash Budget: It is a statement showing the estimated cash inflows and cash outflows over a
planning period
Purpose of cash budget:
Estimating cash requirements;
Planning short-term finance planning;
Scheduling payments, in respect of acquiring capital goods;
Planning and phasing the purchase of raw materials;
Evolving and implementing credit policies;
Checking and verifying the accuracy of long-term cash forecasting.
Preparation of Cash Budget
1. Selection of period of budget
2. Selection of actor that has bearing on cash flows:
Operating cash flows
Financial cash flows

Management of Cash Flows

A. Accelerating cash collections:
Prompt billing and cash discount
Minimising deposit float
Concentration banking
Lock-box system
B. Slowing cash payments:
Paying on last date
Centralised payments
Paying the float
Optimum Cash Balance
Another aspect of cash management is knowing the optimal cash balance.
There are a number of methods that try to determine the magical cash balance, which should be
targeted so that costs are minimized and yet adequate liquidity exists to ensure bills are paid on
time (hopefully with something left over for emergency purposes).
One of the first steps in managing the cash balance is measuring liquidity.
There are numerous ways to measure this, including:
cash to total assets ratio,
current ratio (current assets divided by current liabilities),
quick ratio (current assets less inventory, divided by current liabilities), and
the net liquid balance (cash plus marketable securities less short-term notes payable, divided by
total assets).
The higher the number generated by the liquidity measure, the greater the liquidity and vice
versa.
There is a trade off, however, between liquidity and profitability that discourages firms from
having excessive liquidity.
CASH MANAGEMENT MODELS
To help manage cash on a day-to-day basis in actual dollars and cents, there are a number of
cash management models.
These include the Baumol Model, Miller-Orr Model, and the Stone Model.
under Certainty: Baumols Model
under Uncertainty: The MillerOrr Model
Baumol Model: The cash management model that determines optimum cash balance on the basis
of EOQ concept.
Baumols ModelAssumptions
The firm is able to forecast its cash needs with certainty.
The firms cash payments occur uniformly over a period of time.
The opportunity cost of holding cash is known and it remains stable over time.
The firm will incur the same transaction cost whenever it converts securities to cash.

 Elements of total cost = Conversion cost + opportunity cost

(a) Conversion cost = Cost per conversion [Expected cash need Amount of marketable
securities]
(b) Opportunity cost = Interest lossed x [Average cash balance]
Baumols Model
The firm incurs a holding cost for keeping the cash balance. It is an opportunity cost; that is, the
return foregone on the marketable securities. If the opportunity cost is k, then the firms holding
cost for maintaining an average cash balance is as follows:
The firm incurs a transaction cost whenever it converts its marketable securities to cash. Total
number of transactions during the year will be total funds requirement, T, divided by the cash
balance, C, i.e., T/C. The per transaction cost is assumed to be constant. If per transaction cost is
c, then the total transaction cost will be:
The total annual cost of the demand for cash will be:
The optimum cash balance, C*, is obtained when the total cost is minimum. The formula for
the optimum cash balance is as follows:
Illustration
Advani Chemical Limited estimates its total cash requirement as Rs.2 crore next year. The
companys opportunity cost of funds is 15% per annum. The company will have to incur Rs 150
per transaction when it converts its short-term securities to cash. Determine the optimum cash
balance. How much is the total annual cost of the demand for the optimum cash balance? How
many deposits will have to be made during the year?
Annual Cost Will be
The Total cost will be:
The Miller - Orr Model
The Miller-Orr Model provides a formula for determining the optimum cash balance (Z), the
point at which to sell securities to raise cash (lower limit L) and when to invest excess cash by
buying securities and lowering cash holdings (upper limit H).
Depends on:
transaction costs of buying or selling securities
variability of daily cash (incorporates uncertainty)
return on short-term investments
The Miller - Orr Model
Example: Suppose that short-term securities yield 5% per year and it costs the organization $50
each time it buys or sells securities (TC). The daily variance of cash flows is $1000 (V) and your
bank requires $1,000 minimum checking account balance (L).*

The Miller-Orr Model

- Upper Limit
The upper limit for the cash account (H) is determined by the equation:
H = 3Z - 2L
where:
Z = Target cash balance
L = Lower limit
In the previous example:
H = 3 ($4,000) - 2($1,000) = $10,000
Average Cash Balance
Average Cash Balance (W)
The Miller - Orr Model
Problem
LKG Co.has a policy of maintaining a minimum cash balance of 5,00,000. The S.D of daily
cash flows is 2,00,000.The annual interest rate is 14%.The transaction cost is Rs150/transaction.
Determine (1) Upper control limit
(2) Return point
(3) Average cash balance
Indicate as to what will happen if limits are reached.

STONE MODEL
The Stone Model is somewhat similar to the Miller-Orr Model insofar as it uses control limits.
It incorporates, however, a look-ahead forecast of cash flows when an upper or lower limit is
hit to take into account the possibility that the surplus or deficit of cash may naturally correct
itself.
If the upper control limit is reached, but is to be followed by cash outflow days that would
bring the cash balance down to an acceptable level, then nothing is done.
If instead the surplus cash would substantially remain that way, then cash is withdrawn to get
the cash balance to a predetermined return point.
Of course, if cash were in short supply and the lower control limit was reached, the opposite
would apply. In this way the Stone Model takes into consideration the cash flow forecast.
Investing Surplus Cash
Short Term Investment Opportunities

 Treasury bills
Commercial papers
Certificates of deposits
Bank deposits
Inter-corporate deposits
Money market mutual funds
Problem:Short term cash forecasting
A firm makes 80% of its sales on a 30 day credit. Actual experience is that 80% debtors are
realised after 1 month&20% after 2 months after goods are sold. Sales forecasts for
Jan,Feb,Mar,& April 2007 are : 550,660,700 &1000respectively. However, the actual sales for
Nov and Dec, 2006 are 500 & 600.
Answer
Prepare Cash forecasts for Jan,Feb,Mar &Apr.
Nov Dec Jan Feb Mar Apr
Total sales: 500 600 550 660 700 1,000
Credit (80%) 400 480 440 528 560 800
Collections;
1 month - 320 384 352 422 448
2 months - - 80 96 88 106
Total collection 464 448 510 554
Cash sales 110 132 140 200
Total sales receipts 574 580 650 754
Cash Budget -Problem
MM Co furnishes the details as :
1. Credit sales :75% of sales
2. 60% of credit sales collected after 1month 30% after 2 months &10% after 3 months.
3. Actual sales(2006) Forecast sales(2007)
Oct 1,20,000 Jan 60,000
Nov 1,40,000 Feb 80,000
Dec 1,60,000 Mar 80,000
Apr 1,20,000
May 1,00,000
June 80,000
July 1,20,000
4. Profit margin 20%
5. Anticipated sales of each month are purchased & paid in the preceding month.
6. Expected operating expenses are: Jan:12,000, Feb:16,000,Mar:20,000,Apr:20,000,
May:16,000 June: 14,000.
7. Interest 12% Debentures Rs 1,00,000 is to be paid in each quarter
8. An advance tax of 20,000 . Is due in Apr
9. A Purchase of equipment of Rs 12,000 to be made in June
10. Cash balance on 31st Dec : 40,000 (Min). Borrowings in multiples of 2,000 on a monthly

basis @ 18% per year

11. Interest is payable on the 1st of the month after the borrowing.
12. Rent is 800 per month.
Prepare a cash budget for the 6 month period from jan.
Problem on Lock Box
The Divya Paints Ltd., is currently following a centralized collection System. Most of its
customers are located in the cities of Northern India. The remittances mailed by customers to the
Central location take four days to reach. Before depositing the remittances in the bank, the firm
loses two days in processing them. The daily average collection of the firm is Rs.100,000.
The company is thinking of establishing a lock-box system. It is expected that such a system
will reduce mailing time by one day and processing time by one day.
Find out the reduction in cash balances expected to result from the adoption of the lock-box
system.
Determine the opportunity cost of the present centralized collection system if the interest rate is
assumed to be 18 per cent.
Should the lock-box system be established if its annual cost is Rs.24,500/-

Solution for Log box system

1) The total time saved by the firm by establishing the lock box system is 2 days.
Reduction in cash balances =Times saved x daily avg. collection
Collection 2x Rs.100,000 = Rs.200,000
2) Opportunity cost =18% x Rs.200,000 =Rs.36,000
3) The lock-box system should be established because the opportunity cost of the present system
(Rs.36,000) is higher than the cost of the lock-box system( Rs.24,500).
Basis of Selecting Investment Avenues
Safety
Marketability
Yield
Maturity
Money Market Instruments
Units of MFs
Treasury bills
Certificate deposits
Inter-corporate deposits

 Bills discounting
Commercial papers
Bankers acceptance
Badla financing
Analysis of Cash Management
Size of cash
Current ratio
Quick ratio
Net cash flows to current liabilities
Coverage of current liabilities
Cash turnover ratio

Cash Flow rules

1. Never Run Out of Cash.
Running out of cash is the definition of failure in business. Make the commitment to do what it
takes so it does not happen to you.
2. Cash Is King
It's important to recognize that cash is what keeps your business alive. Manage it with the care
and attention it deserves. It's very unforgiving if you don't.
Remember, Cash Is King, because No Cash = No Business.
3. Know the Cash Balance Right Now.
What is your cash balance right now? It's absolutely critical that you know exactly what your
cash balance is.
Even the most intelligent and experienced person will fail if they are making business decisions
using inaccurate or incomplete cash balances. That's the reason why business failures are not
limited to amateurs or people new to the business world.
4. Do Today's Work Today.
The key to keeping an accurate cash balance in your accounting system is to do today's work
today. When you do this, you will have the numbers you need - when you need them.
5. Either You Do the Work or Have Someone Else Do It.
Here is a simple rule to follow to make sure you have an accurate cash balance on your books.
You do the work or have someone else do it.
Those are the only two choices you have. The work must be done. It's like mowing the lawn. You
can't just ignore it. Someone has to do it. That means either you do it or have someone else do it.
6. Don't Manage From the Bank Balance.
The bank balance and the cash balance are two different animals. Rarely will the two ever be the
same. Don't make the mistake of confusing them.
It's futile (and frustrating) to attempt to manage your cash flow using the bank balance. It's a
prescription for failure. You reconcile your bank balance. You don't manage from it.
7. Know What You Expect the Cash Balance to be Six Months From Now.
What do you expect your cash balance to be six months from now? This one question will
transform the way you manage your business.

This question really gets to the heart of whether you are managing your business or whether your
business is managing you.
8. Cash Flow Problems Don't "Just Happen."
You would be shocked and amazed at the number of businesses that fail because the owner did
not see a cash flow problem in time to do something about it.
The key is to always be able to answer the question - what do I expect my cash balance to be six
months from now?
9. You Absolutely, Positively Must Have Cash Flow Projections.
Cash flow projections are the key to making wise and profitable business decisions. They give
you the answer to the all-important question from Rule # 7.
It's impossible to run your business properly without them.
10. Eliminate Your Cash Flow Worries So You Are Free to Do What You Do Best - Take Care of
Customers and Make More Money.
This is the real key to your success in business. The reason you have to make sure you have the
cash flow of your business under control is so you are free to focus all your time and talents
where you can make the most difference in your business.
When you have your cash flow under control, you are free from worry, doubt and concern. You
have the cash flow information you need to make sure that everything you do each day in your
business is clearly focused on making your business better.
You have the information you need to measure your progress using the amount of cash you
generate (and keep) for yourself and your business as your ultimate financial measurement. In
subsequent columns, I will delve into the specifics to help you achieve each step.

CASH BUDGET PROBLEMS

1. From the following information prepare cash budget for VSI Co. Ltd.,
Particulars Jan
(Rs.) Feb
(Rs.) March
(Rs.) April
(Rs.)
Opening cash balance 20,000 - - Collection from customers 1,30,000 1,60,000 1,65,000 2,30,000
Payments
Raw materials purchase 25,000 45,000 40,000 63,200
Salary and wages 1,00,000 1,05,000 1,00,000 1,14,200
Other expenses 15,000 10,000 15,000 12,000
Income tax 6,000 - - Machinery - - 20,000 The firm wants to maintain a minimum cash balance of Rs.25, 000 for each month. Creditors are

allowed one-month credit. There is no lag in payment of salary and other expenses.
1. BPL Ltd. Wishes to arrange overdraft facilities with its bankers during the period April to
June, 2008 when it will be manufacturing mostly for stock. Prepare a Cash Budget for the above
period from the following data, indicating the extent of the bank facilities the company will
require at the end of each month:
Credit sales Purchases Wages
Rs. Rs. Rs.
February 2008 1, 80,000 1, 24,800 12,000
March 1, 92,000 1, 44,000 14,000
April 1, 08,000 2, 43,000 11,000
May 1, 74,000 2, 46,000 10,000
June 1, 26,000 2, 68,000 15,000
50 per cent of credit sales are realised in the month following the sales and the remaining 50 per
cent in the second month following. Creditors are paid in the month following the month of
purchase. Cash at bank on 1-4-2008 (estimated) Rs.25, 000.
2. Summarised below are the income and expenditure forecasts of Gemini Ltd. For the months of
March to August, 2008:
Months Sales Purchases
(all credit) Wages Manufac
-turing
Expenses Office
Expenses Selling
Expenses
March 60,000 36,000 9,000 4,000 2,000 4,000
April 62,000 38,000 8,000 3,000 1,500 5,000
May 64,000 33,000 10,000 4,500 2,500 4,500
June 58,000 35,000 8,500 3,500 2,000 3,500
July 56,000 39,000 9,500 4,000 1,000 4,500
August 60,000 34,000 8,000 3,000 1,500 4,500
You are given the following further information:
(a) Plant costing Rs.16,000 is due for delivery in July payable 10% on delivery and the balance
after three months.
(b) Advance tax of Rs.8,000 is payable in March and June each.
(c) Period of credit allowed (i) by suppliers 2 months and (ii) to customers 1 month.
(d) Lag in payment of manufacturing expenses month.
(e) Lag in payment of all other expenses 1 month.
You are required to prepare a cash budget for three months starting on 1st May, 2008 when there
was a cash balance of Rs.8,000.

3. Draw out cash budget for January to March from the following information.
1) Cash and Bank Balance on 1.1.2008 2, 00,000
2) Actual and budgeted sales
September 6, 00,000 (Actual)
October 6, 50,000 ( )
November 7, 00,000 ( )
December 7, 50,000 ( )
January 8, 00,000 (Budgeted)
February 8, 20,000 ( )
March 8, 90,000 ( )
3) Purchases Actual and budgeted figures are:
September 3, 60,000 (Actual)
October 4, 00,000 ( )
November 4, 80,000 ( )
December 4, 50,000 ( )
January 4, 80,000 (Budgeted)
February 4, 00,000 ( )
March 5, 00,000 ( )
4) Wages and expenses Actual and budgeted.
Wages Expenses
Rs. Rs.
November (Actual) 1, 50,000 50,000
December ( ) 1, 50,000 60,000
January (Budgeted) 1, 80,000 80,000
February ( ) 1, 80,000 80,000
March ( ) 2, 00,000 80,000
5) Special items:
a) Advance payment of income tax in march 2008 Rs.50,000
b) Plant acquired and price paid in January 2008 Rs.1,00,000
6) 10% purchases and sales are on cash basis.
7) Time
Credit Sales 2 months
Credit Purchase 1 month
Wages month
Expenses month

4. Prepare cash budget for the 3 months ending 30-06-2008 from the following information.
a)
Month Sales Materials Wages Overheads
February 14,000 9,600 3,000 1,700
March 15,000 9,000 3,000 1,900
April 16,000 9,200 3,600 2,000
May 17,000 10,000 3,200 2,200
June 18,000 10,400 6,000 2,300
b) Credit terms are: Sales / Debtors 10 percent, sales are on cash, 50 percent of the credit, sales
are collected next month and the balance in the following month.
Creditors (suppliers) 2 months; Wages month; overheads month
c) Cash and Bank balance as on 1st April 2008 is expected to be Rs.6, 000.
d) Other information:
- Machinery will be installed in Feb.2008 at a cost of Rs.96, 000. The monthly instalment of
Rs.2,000 is payable from April onward.
- Dividend at 5 percent on preference share capital of Rs.20, 000 will be payable on May and 1st
June.
- Advance to be received for sale of vehicles Rs.9, 000 in June.
- Dividends from investments amounting to Rs.1,000 are expected to be received in June.
- Income tax (advance) to be paid in June is 2,000.
Solution to Cash budget ND Lock Box Problems
Solution to Cash Budget
Jan
Rs Feb
Rs Mar
Rs. Apr.
Rs. May
Rs June
Rs Total
Rs
Receipts
Cash Sales 36,000 48,500 43,000 44,300 51,250 54,350 277,400
Collections from debtors - 36,000 48,500 43,000 44,300 51,250 223,050
Bank loan - - - - 30,000 - 30,000
Total 36,000 84,500 91,500 87,300 125,550 105,600 530,450
Payments
Materials - 25,000 31,000 25,500 30,600 37,000 149,100
Salaries and wages 10,000 12,100 10,600 25,000 22,000 23,000 102,700
Production of Overheads - 6,000 6,300 6,000 6,500 8,000 32,800
Office and Selling overheads - 5,500 6,700 7,500 8,900 11,000 39,600
Sales Commission 2,160 2,910 2,580 2,658 3,075 3,261 16,644

Capital expenditures - 8,000 - 25,000 - - 33,000

Dividend - - - - - 35,000 35,000
Total 12,160 59,510 57,180 91,658 71,075 117,261 408,844
Net cash flow 23,840 24,990 34,320 (4,358) 54,475 (11,661) 121,606
Balance, beginning of month 72,500 96,340 121,330 155,650 151,292 205,767 194,106
Balance, end of month 96,340 121,330 155,650 151,292 205,767 194,106 315,712
Lock Box Problem:
1) The total time saved by the firm by establishing the lock box system is 2 days.
Reduction in cash balances = Times saved x daily average collection
Collection
2x rs.100,000 = Rs.200,000
2) Opportunity cost = 18% x Rs.200,000 = Rs.36,000
3) The lock-box system should be established because the opportunity cost of the present system
(Rs.36,000) is higher than the cost of the lock-box system( Rs.24,500).

CASH MANAGEMENT
Cash management is a broad area having to do with the collection, concentration, and
disbursement of cash including measuring the level of liquidity, managing the cash balance, and
short-term investments.
If at any time, because of a lack of cash, a corporation fails to pay an obligation when it is due,
the corporation is insolvent. Insolvency is the primary reason firms go bankrupt. Obviously, the
prospect of such dire consequence compels companies to manage their cash with care. Moreover,
efficient cash management means more than just preventing bankruptcy. It improves the
profitability and reduces the risk the firm is exposed to.
COLLECTION AND DISBURSEMENT
Cash collection systems aim to reduce the time it takes to collect the cash that is owed to the firm
(for example, from its customers). The time delays are categorized as mail float, processing float,
and bank float. Obviously, an envelope mailed by a customer containing payment to a supplier
firm does not arrive at its destination instantly. Likewise, the moment the firm receives payment
it is not deposited in its bank account. And finally, when the payment is deposited in the bank
account oftentimes the bank does not give immediate availability to the funds. These three
"floats" are time delays that add up quickly, requiring the firm in the meantime to find cash
elsewhere to pay its bills. Cash management attempts to decrease the time delays in collection at
the lowest cost. A collection receipt point closer to the customer, such as a lock box, with an
outside third-party vendor to receive, process, and deposit the payment (check) will speed up the
collection. For example, if a firm collects $10 million each day and can permanently speed up
collections by five days, at 6 percent interest rates, then annual before-tax profits would increase
by $3 million. The techniques to analyze this case would utilize data involving where the
customers were; how much and how often they pay; the bank they remit checks from; the
collection sites the firm has (their own or a third-party vendor); the costs of processing
payments; the time delays involved for mail, processing, and banking; and the prevailing interest

rate that can be earned on excess funds.

Once the money has been collected, most firms then proceed to concentrate the cash into one
center. The rationale for such a move is to have complete control of the cash and to provide
greater investment opportunities with larger sums of money available as surplus. There are
numerous mechanisms that can be employed to concentrate the cash, such as wire transfers,
automated clearinghouse transfers, and checks. The tradeoff is between cost and time.
Disbursement is the opposite of collection. Here, the firm strives to slow down payments. It
wants to increase mail delays and bank delays, and it has no control over processing delay.
OPTIMAL CASH BALANCE
Another aspect of cash management is knowing the optimal cash balance. There are a number of
methods that try to determine the magical cash balance, which should be targeted so that costs
are minimized and yet adequate liquidity exists to ensure bills are paid on time (hopefully with
something left over for emergency purposes). One of the first steps in managing the cash balance
is measuring liquidity. There are numerous ways to measure this, including: cash to total assets
ratio, current ratio (current assets divided by current liabilities), quick ratio (current assets less
inventory, divided by current liabilities), and the net liquid balance (cash plus marketable
securities less short-term notes payable, divided by total assets). The higher the number
generated by the liquidity measure, the greater the liquidity and vice versa. There is a trade off,
however, between liquidity and profitability that discourages firms from having excessive
liquidity.
CASH MANAGEMENT MODELS
To help manage cash on a day-to-day basis in actual dollars and cents, there are a number of cash
management models. These include the Baumol Model, Miller-Orr Model, and the Stone Model.
BAUMOL MODEL.
The Baumol Model is similar to the Economic Order Quantity (EOQ) Model. Mathematically it
is:
where C = the optimal amount of cash to be acquired when reaching a threshold balance,
F = the fixed cost of acquiring the cash C amount,
S = the amount of cash spent during a time interval,
i = the interest rate expressed in the same time interval as S
One shortcoming of this model is that it accommodates only a net cash outflow situation as
opposed to both inflows and outflows. Also, the cash outflow is at a constant rate, with no
variation.
MILLER-ORR MODEL.
The Miller-Orr Model rectifies some of the deficiencies of the Baumol Model by accommodating
a fluctuating cash flow stream that can be either inflow or outflow. The Miller-Orr Model has an
upper limit U and lower limit L
When there is too much cash and U is reached, cash is taken out (to buy short-term securities to
earn interest) such that the cash balance goes to a return (R) point. Otherwise, if there is too little
cash and L is reached, cash is deposited (from the short-term investments) to replenish the
balance to R. The equations of the Miller-Orr Model are:
where R = the return point,
f = the fixed cost for each transaction to withdraw or deposit cash,
s2 = the variance of the cash flows,

i = the interest rate per same time period as s2,

U = the upper limit
L is determined by other means, for example, compensating balance requirement, minimum
balance to avoid bank service charges on checking account, or zero.
STONE MODEL.
The Stone Model is somewhat similar to the Miller-Orr Model insofar as it uses control limits. It
incorporates, however, a look-ahead forecast of cash flows when an upper or lower limit is hit to
take into account the possibility that the surplus or deficit of cash may naturally correct itself. If
the upper control limit is reached, but is to be followed by cash outflow days that would bring
the cash balance down to an acceptable level, then nothing is done. If instead the surplus cash
would substantially remain that way, then cash is withdrawn to get the cash balance to a
predetermined return point. Of course, if cash were in short supply and the lower control limit
was reached, the opposite would apply. In this way the Stone Model takes into consideration the
cash flow forecast.
The goals of these models are to ensure adequate amounts of cash on hand for bill payments, to
minimize transaction costs in acquiring cash when deficiencies exist, and to dispose of cash
when a surplus arises. These models assume some cash flow pattern as a given, leaving the task
of cash collection, concentration, and disbursement to other methods.
SHORT-TERM INVESTMENT DECISIONS
A key cash management problem (including how much money and for how long) concerns in
which money market instruments should the temporary excess funds be placed. This short-term
investment decision necessitates the analysis of return (need to annualize returns in order to
compare) and liquidity. Only short-term investments meet the liquidity test, as long-duration
instruments expose the investor to too much interest rate risk. In addition, federal government
obligations are popular due to the absence of default risk and ease of resale in the secondary
market. Nonetheless, there are numerous money market securities available with varying
characteristics from many types of issuers.
Cash management is evolving with the increasing acceptance and use of electronic payments,
such as debit cards. Shifting from paper-based payments to electronic transfers reduces the
uncertainty in cash flow forecasting. The change in form of payment decreases both float and per
item transaction costs. Stumbling blocks to the complete switchover to electronic payments
include the initial equipment investment for businesses and resistance by consumers who still
prefer checks. Nevertheless, the use of electronic versus paper payments is gaining, affecting the
importance of current cash management techniques.
CASH MANAGEMENT
Q.1 Explain the three principal motives for holding cash.
A.1 Cash is required to meet a firms transactions and precautionary needs. A firm needs cash to
make payments for acquisition of resources and services for the normal conduct of business. It
keeps additional funds to meet any emergency situation. Some firms may also maintain cash for
taking advantages of speculative changes in prices of input and output.
Cash in the basic input needed to keep the business running on a continuous basis. Cash shortage
will disrupt the firms manufacturing operations, while excessive cash will simply remain idle,
without contributing anything towards the firms profitability. So, firm should have sufficient
cash, neither more nor less.

The cash for precautionary motive is the need to hold cash to meet contingencies in the future. It
provides cushion or buffer to withstand some unexpected emergency.
Q.2 What are the advantages of cash planning? How does cash budget help in planning the firms
cash flows?
A.2 Cash planning is a technique to plan and control the inflow and outflow of cash. Cash
planning helps to anticipate the future cash flows and cash needs of the firm and reduces the
possibility of idle cash balances (which lowers firms profitability) and cash deficits (which can
cause the firms failure). It protects the financial condition of the firm, and is crucial in
developing the overall operating plans of the firm.
Cash budget is the most significant device to plan for and control cash receipts and payments. A
cash budget is a summary statement of the firms expected cash inflows and outflows over a
projected time period. It gives information on the timing and magnitude of expected cash flows
and cash balances over the projected period. The cash budget may differ from firm to firm.
Monthly cash budgets should be prepared by a firm whose business is affected by seasonal
variations. Daily or weekly cash budgets should be prepared for determining cash requirements if
cash flows show extreme fluctuations. Cash budgets for a longer interval should be prepared if
cash flows are relatively stable.
Q.3 Explain and illustrate the utility of cash budget.
A.3 The cash budget helps in determining the cash requirements for a pre-determined period to
run a business. One of the significant roles of the cash budget is to pin-point when the money
will be needed and when it can be repaid. This helps the financial manager to negotiate short
term financial arrangement with banks. Cash budget also help in managing the investment of
surplus cash in marketable securities. A carefully and skillfully designed cash budget helps a firm
to select securities with appropriate maturities and reasonable risk, and maximize profit by
investing idle funds. Multi-divisional firms use cash budgets as a tool to coordinate the flow of
funds between their various divisions as well as to make financing arrangements for these
operations. Cash budget may also be useful in determining the margins or minimum balances to
be maintained with banks. It also supports to scheduling payments in connections of short-term
and long-term debt repayments as well as for capital expenditures programmes, etc.
Q.4 Illustrate with example the modus operandi of preparing a cash budget.
A.4 Two most commonly used methods of preparing a cash budget are (1) the receipts and
disbursements method, and (2) the adjusted income method.
Receipts and disbursements method: Developing a forecast for cash inflows is the first step in
preparing a cash forecast or cash budget. Three broad sources of cash inflows can be identified:
(i) operating, (ii) non-operating and (iii) financial. Cash sales and collections from customers
form the most important part of the operating cash inflows. The operating cash inflows are
reduced to the extent of sales discounts, returns and allowances and bad debts. Non-operating
cash inflows include sale of old assets and dividend and interest income. Borrowings and
issuance of securities are external financial sources, and part of financial cash inflows.
Next step in the preparation of cash budget is the estimate of cash outflows. Cash outflows
include
1. Operating outflows, i.e., cash purchases, payments to suppliers of materials, advances to
suppliers, wages and salaries and other operating expenses

2. Capital expenditures
3. Contractual payments
4. Repayment of loan and interest and tax payments and
5. Discretionary payments like ordinary and preference dividend.
Adjusted Income Method: This method is also known as sources and uses approach. It is a
projected cash flow statement which has three sections, i.e., sources of cash, uses of cash and the
adjusted cash balance. It also helps in anticipating the working capital movements. In preparing
the adjusted net income forecast items such as net income, depreciation, taxes, dividends, etc.
can easily be determined from the companys annual operating budget. It separately takes into
account the movements in the working capital items, and thus helps to keep a control on a firms
working capital.
Q.5 Explain the technique that can be used to accelerate the firms collections.
A.5 Cash collections can be accelerated by reducing the lag or gap between the time a customer
pays bill and the time the cheque is collected and funds become available for the firms use. For
this purpose, a firm can use decentralized collection system and lock-box system to speed up the
collections.
A decentralized collection procedure, called concentration banking, is a system of operating
through a number of collection centres, instead of a single collection centre centralized at the
firms head office. The basic purpose of the decentralized collections is to minimize the lag
between the mailing time from customers to the firm and time when the firm can make use of the
firm. Decentralized mailing system saves mailing and processing time, and thus, reduces the
deposit float, and consequently, the financing requirements.
Lock-box system: In a lock-box system, the firm establishes a number of collection centres,
considering customer locations and volume of remittances. At each centre, the firm hires a post
office box and instructs its customers to mail their remittances to the box. The firms local bank
is given the authority to pick up the remittances, and deposits the cheque in the firms account.
Q.6 What are the advantages of decentralized collection over a centralized collection?
A.6 Under the decentralized collections, the firm will have a large number of bank accounts
operated in the areas where the firm has its branches, instead of one bank account at one place in
centralized collection system.
Decentralized collection system saves mailing and processing time and, thus, reduces the deposit
float, and consequently, the financing requirements. This system results in potential savings
which should be compared with the cost of maintaining the system.
It must be noticed that now a lot of developments and improvements have taken place in the
banking in India. Now a firm can deposit cheque anywhere and the credit will be available
immediately where the firm operates its account.
Q.7 What is a lock-box system? How does it help to reduce the cash balances?
A.7 In a lock-box system, the firm establishes a number of collection centres, considering
customer locations and volume of remittances. At each centre, the firm hires a post office box
and instructs its customers to mail their remittances to the box. The firms local bank picks up the
cheques and deposits in the firms accounts.
The lock-box system eliminates the period between the time cheques are received and deposited
in the bank for collection by firm. The cheques are deposited immediately and their collection

process start sooner, which results into reduced deposit floats, and may in turn reduce the cash
balances.
Q.8 Distinguish between a deposit float and a payment float. What are the advantages and
dangers of playing the float? Explain the techniques for managing float.
A.8 The collection float means the time gap between cheques sent by customer which are not yet
collected. This time gap, i.e., delay caused by the mailing time, (the time taken by cheque in
transit), and the processing time (the time taken by the firm in processing cheque for internal
accounting purposes).
When the firms actual bank balance is greater than the balance shown in the firms books, the
difference is called disbursement or payment float.
Playing the float means to maximize the availability of funds. The difference between the total
amount of cheques drawn on a bank account and the balance shown on the banks book is caused
by transit and processing delays. If the financial manager can accurately estimate the transit and
processing delays time, he or she can invest the float during the float period to earn a return. It
is a risky game and should be played very cautiously.
Q.9 What are the objectives of a firm in controlling its disbursements? How can the
disbursements be slowed down?
A.9 Disbursements arise due to trade credit. The firms effective control of disbursements can
help in conserving cash and reducing the financial requirements. The firm should make payments
using credit terms to the fullest extent. Delaying disbursements result in maximum availability of
funds. For proper control of disbursements, a centralized payment system may be advantageous,
and payments may be made from a single central account.
Q.10 How can the appropriate level of operating cash balance be determined? How does
uncertainty affect this problem?
A.10 The firm should maintain optimum - neither more nor less - cash balance for transaction
purposes. It may also carry additional cash as buffer or safety stock. The amount of cash balance
will depend on the risk-return trade-off.
The Baumols Cash Management Model provides a formal approach for determining a firms
cash balance under certainty. The Baumols model makes these assumptions: (1) the firm is able
to forecast its cash needs with certainty, (2) cash payments occur uniformly over a period of
time, (3) opportunity cost of holding cash is known, and (4) firm will incur the same transaction
cost whenever it converts securities to cash. The optimum cash balance, C*, is obtained when the
total cost is minimum. The formula for the optimum cash balance is as follows:
where C* is the optimum cash balance, c is the cost per transaction, T is the total cash needed
during the year and k is the opportunity cost of holding cash balance. The optimum cash balance
will increase with increase in the transaction cost and total funds required and decrease with the
opportunity cost.
The Miller-Orr Model provides an approach for determining optimum cash balance under
uncertainty. The model allows for daily cash flow variations. As per this model, there are upper
control limits and lower control limits. The cash balance at any point of time is not allowed to go
above the upper control limit, while it is not allowed to fall below the lower limit. In between

these two levels, there is a returning point. Once cash balances reaches to upper control limit
(UCL), the balance is reduced to returning point by investing in marketing securities. On the
other hand, when cash balances touches to lower control limit, enough marketable securities are
disposed off to restore the cash balance to returning point.
The formula for determining the distance between upper and lower control limits (called Z) is as
follows:
We can notice from the equation that the upper and lower limits will be far off from each other
(i.e. Z will be larger) if transaction cost is higher or cash flows show greater fluctuations. The
limits will come closer as the interest rate increases. Z is inversely related to the interest rate. It is
noticeable that the upper control limit is three times above the lower control limit and the return
point lies between the upper and the lower limits. Thus,
Upper Limit = Lower Limit + 3Z Return Point = Lower Limit + Z
The net effect is that the firm holds the average cash balance equal to:
Average Cash Balance = Lower Limit + 4/3 Z
Q.11 Explain the criteria that a firm should use in choosing the short term investment alternatives
in order to invest surplus cash.
A.11 A firm can invest its excess cash in many types of securities or short-term investment
opportunities. The primary criterion in selecting a security will be its quickest convertibility into
cash. The firm should examine the basic features of security: safety, maturity and marketability.
The firm would invest in very safe securities as the cash balance invested in them is needed in
near future. The short-term securities are preferred by the firm for the purpose of investing
excess cash. If the security can be sold quickly without loss of price, it is highly liquid or
marketable. The difference in marketability and also the default risk cause differences in the
security yields.
Q.12 Other things remaining constant, what effect would the following events have on the
average cash balance that a firm keeps for transaction purposes? Explain your answer.
a) Increase in interest rates
b) It becomes more expensive to transfer funds from cash to securities
and vice versa.
c) The variability of net cash flow increases.
A.12 a) Increase in interest rates encourages the financial manager to review the cash needs for
transaction purpose, and to reduce the optimum cash balance needs to earn the better yields by
investing money in short-term securities or marketable securities.
b) If the transfer of funds from cash to securities and vice-versa becomes more expensive, then
financial manager likes to have lesser total transaction costs for conversion. This will result into
increase in optimum cash balance.
c) As the variability of cash inflows increases, so financial manager would not like to have cash
shortages, i.e., stock-out situations, so he will maintain larger amount of optimum cash balance.