MANAGEMENT OF CASH
April 27, 2010
Cash is a non-earning asset. Excessive cash balances reduce the rate of return on equity and the value of a firm’s stock. The goal of cash-management is to minimize the amount of cash a firm must hold in order to conduct its normal business activities yet at the same time to have sufficient cash to:
· Take trade decisions
· Maintain its credit rating
· Meet unexpected cash needs
Firms hold cash for the following reasons:
- Transaction balances are held to provide the cash needed to conduct normal business operations – to make purchases and other payments. For transaction purposes, a firm may invest in short-term marketable securities.
- Speculative balances to enable the firm take advantage of favorable business opportunities eg. Bargain purchases, trade discounts, attractive interest rates and in international trade, favorable exchange rate fluctuations. It can also be for investment purposes. However, most firms do not engage in speculations especially if they can borrow easily and they can also use marketable securities to satisfy their speculative needs.
- Precautionary balances to meet future contingencies or emergencies. It is considered as a safety margin to act as a financial reserve. This may be in cash or in highly-liquid and low-risk marketable securities.
- Compensating balances to offset the banking costs incurred through the provision of banking services such as check clearing. Banks usually require companies to maintain some deposit in low-interest or non-interest bearing accounts to cater for the services they render to these companies.
When a firm holds cash in excess of some necessary minimum, it incurs an opportunity cost. The opportunity cost is the interest income that could have been earned in the next best use of that cash e.g. investment in marketable securities.
Cash planning is a technique used to plan and control the use of cash. It helps to anticipate future cash flows and the needs of the firm and reduces the possibility of idle cash balances and cash deficits. It protects the financial condition of the firm by developing a projected cash statement from a forecast of expected cash inflows and out flows for a period.
Cash should be well managed to ensure that the firm has sufficient cash levels at all times to facilitate the smooth flow of its operations. In order to balance the cash inflows and outflows, a firm should follow the following strategies:
1. Prepare a periodic Cash Plan. This will be in the form of a cash budget which will forecast the expected receipts and expenditures of a firm for a period of time and can be used to indicate periods when the firm will have cash deficits or surpluses.
2. Invest Surplus Cash. If the firm has surplus cash during a particular period, it should be invested in short-term investments like bonds and shares so as to earn a return and act as a reserve of cash in times of emergencies.
3. Manage Cash-Flows. There should be proper control of cash receipts and payments so as to ensure the firm doesn’t default on its obligations when they fall due.
4. Maintain Optimum Cash Balances. This is the ideal level of cash-balance a firm should maintain at all times- just enough to facilitate the smooth flow of the company’s operations. The cost of excess cash and the danger of cash deficiency should be matched to determine the optimum level of cash balances.
This is a summary statement of a firm’s expected cash receipts and payments over a specific period of time. A cash budget projects cash inflows and outflows over some specified period of time. The basis is mostly the sales forecast and the level of assets that will be required to meet those forecasts. A cash budget can be created for any interval but firms typically use a monthly cash budget for the coming year, mostly for planning purposes and a daily or weekly budget for actual cash control.
A typical cash budget consists of three sections:
1. Sales and Expenses worksheet that summarizes the firm’s sales income and expenses incurred in purchasing materials
2. Cash Gain or Loss section that indicates the cash inflows and outflows with the ‘bottom line’ indicating either a gain or loss
3. Cash surplus or Loan requirement (Net Cash Balances) section that summarizes the firm’s surplus cash held or total loans needed.
This will be estimated by deducting total expenses for a given period e.g. a month from the total cash receipts for that period. The result will either indicate a surplus or deficit.
-In case of surplus, it can be invested in bonds, equities or in savings accounts
- In case of a deficit, it can be bridged by:
a) Borrowing short-term funds e.g. through overdrafts.
b) Delaying capital expenditures until the firm’s cash position improves.
c) Requesting suppliers for a longer credit period.
d) Delay payment of taxes.
e) Postpone payment of dividends.
NB: - Since the cash budget represents a forecast, all the values shown are expected values.
– If the firm’s inflows and outflows are not uniform over the budget interval, the cash budget for that period will overestimate or underestimate the firm’s cash needs.
– A cash budget can be used to help set the firm’s target cash balance i.e. the desired cash balance that a firm plans to maintain in order to conduct business. The target balance can be adjusted over time depending on the size of the firm’s operations during various business cycles
– Even though depreciation amounts do not appear directly in the budget, they still affect the amount of taxes shown
1. Helps determine future cash flows thus enabling the company to plan for its financing.
2. Helps management know when to borrow and how much to borrow.
3. Helps in determining when there will be a cash surplus so management can plan for its use i.e. whether to pay dividends or invest in short-term securities.
4. Helps management to control expenditure based on the forecasted income and expenditure.
5. Assists management in planning for its obligations and knowing when and how to meet those obligations.
6. Strengthens the liquidity position of a company since it helps a company know its accurate cash position and what measures to take depending on its position.
Disadvantages of Cash Budgeting
1. Uncertainty – It assumes that everything remains constant while in reality, anything can actually happen.
2. Forecasting budgets isn’t always accurate since one can predict expenses but can’t accurately predict income / sales
3. Requires highly skilled personnel to forecast and prepare a cash budget
4. If there is any deviation from the fixed budget, a new budget has to be designed again.
A primary responsibility of a financial manager is to maintain a sound liquidity position of the
firm so that payments are settled in time. The amount of cash balances to be maintained depends
on the risk-return trade-off.
1. If a firm maintains small cash balances, its liquidity position weakens but its profitability
improves because the funds are invested in other profitable opportunities e.g. marketable
securities. When the firm needs cash, it can sell its marketable securities or borrow.
2. If on the other hand, a firm keeps high cash balances, it will have a strong liquidity position
but its profitability will be low. The potential profit foregone by holding large cash balances
is an opportunity cost to the firm. A firm should therefore maintain optimum cash balances
– not too much and not too little.
The firm’s cash management system should strive to achieve two prime objectives:
1) Enough cash must be on hand to dispense effectively any disbursements that arise in the course of business.
2) The firm’s investment in idle cash balances must be reduced to a minimum.
Effective cash management encompasses proper management of cash inflows and outflows which entails:
a) Synchronizing cash flows – cash inflows coinciding with cash outflows – so as to reduce cash
balances, decrease bank loans, lower interest expenses and increase profits.
b) Using float which is the difference between the firm’s cashbook balances and bank cash
balances. Float management involves controlling the collection and disbursement of cash. The objective in cash collection is to speed up collections and reduce the lag between the time customers pay their bills and the time cash becomes available. The objective in cash disbursement is to control payments and minimize the firm’s costs associated with making payments. Net float is the difference between the balance shown in the firm’s cash book and the balance on the bank’s records. Float reduction can result in considerable benefits in terms of 1) usable funds being released for company use and 2) in the returns produced on these freed funds.
Reasons for a lengthy float.
- Transmission delay due to payments made through the post.
- Delay in banking the payments received.
- Clearance delay – the time needed for a bank to clear a check.
To determine the optimum cash balance, we can use two models:
1. Baumol model – for optimum cash balances under certainty
2. Miller-Orr model – for optimum cash balances under uncertainty.
This model provides a formal approach for determining a firm’s optimum cash balance under certainty.
The method considers cash management to be similar to inventory management. The firm attempts
to minimize the sum of its cost of holding cash and the cost of converting marketable securities
to cash. The model makes the following assumptions:
· The firm is able to forecast its cash needs with certainty.
· The firm’s cash payments occur uniformly over a period of time.
· The opportunity cost of holding cash is known and it does not change over time.
· The firm will incur the same transaction cost whenever it converts securities to cash.
The formula for the optimum cash balance is:
C* = √2cT/k where: C*= optimum cash balance
c = cost per transaction, i.e. cost of replenishing cash
T = total cash needed during the year for transaction purposes
k = opportunity cost of holding cash balance. This is the interest rate on marketable securities.
The optimum cash balance will increase with increase in the per transaction cost and total cash required and decrease with opportunity cost.
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