CORPORATE FINANCE END

TERM PROJECT

ON

CASH MANAGEMENT

Submitted to: Submitted by:

Dr. S.S. Parmar Group 4

Section c

Submitted on:

10, March 2014

LAL BAHADUR SHASTRI INSTITUTE OF MANAGEMENT, DELHI

LAL BAHADUR SHASTRI INSTITUTE OF MANAGEMENT, DELHI

Plot No. 11/7, Sector 11, Dwarka, New Delhi - 110 075

Dated: 10, March 2014

CERTIFICATE

To Whom It May Concern:

This is to certify that the project study entitled CASH MANAGEMENT, submitted by Group 4,

Sec -C, for the partial fulfillment of internal evaluations of the subject CORPORATE FINANCE.

The work has not been submitted elsewhere..

Submitted By-

Shashank Kapoor (140)

Subhash Arora(141)

Chirag Gupta(142)

Keshav Rustagi(143)

Amarnath JV(144)

Parshant Kumar Gupta(145)

Dr. S.S Parmar

(Signature of the Project Guide)

Contents

1. Introduction to Cash

2. Motives for Holding Cash

3. Cash Management

4. Objectives of cash management

5. Controlling level of cash

6. Cash inflows

7. Cash outflows

8. Optimum balance

9. Case Study

10. Trends in Cash Management

Introduction

Cash is the important current asset for the operations of the business. Cash is the

basic input needed to keep the business running on a continuous basis; it is also

the ultimate output expected to be realized by selling the service or product

manufactured by the firm. The firm should keep sufficient cash, neither more

nor less. Cash shortage will disrupt the firms manufacturing operations while

excessive cash will simply remain idle, without contributing anything towards

the firms profitability. Thus, a major function of the financial manager is to

maintain a sound cash position.

Cash is the money which a firm can disburse immediately without any

restriction. The term cash includes coins, currency and cheques held by the

firm, and balances in its bank accounts. Sometimes near-cash items, such as

marketable securities or bank times deposits, are also included in cash. The

basic characteristic of near-cash assets is that they can readily be converted into

cash. Generally, when a firm has excess cash, it invests it in marketable

securities. This kind of investment contributes some profit to the firm.

Cash is the most liquid asset. Cash is common denominator to which all other

current assets can be reduced because receivables and inventories get converted

into cash. Cash is lifeblood of any firm needed to acquire supply resources,

equipment and other assets used in generating the products and services.

Marketable securities also come under near cash, serve as back pool of liquidity

which provide quick cash when needed.

For the purpose of cash management, the term cash not only includes coins,

currency notes, cheques, bank draft, demand deposits with banks but also the

near cash assets like marketable securities and time deposits with bank because

they can readily converted into cash.

Although cash is only 1-3% of total current assets but its management is

very important.

Management of cash includes:

Determination of optimum amount of cash required in the business.

To keep the cash balance at optimum level and investment of surplus cash

in profitable manner.

Motives for holding Cash

In business cash is needed for the following motives

1.Transaction Motive :

The transaction motive requires a firm to hold cash to conducts its business in

the ordinary course. The firm needs cash primarily to make payments for

purchases, wages and salaries, other operating expenses, taxes, dividends etc.

The need to hold cash would not arise if there were perfect synchronization

between cash receipts and cash payments, i.e., enough cash is received when the

payment has to be made.

2.Precautionary Motive :

The precautionary motive is the need to hold cash to meet contingencies in

the future. It provides a cushion or buffer to withstand some unexpected

emergency. The precautionary amount of cash depends upon the predictability

of cash flows. If cash flow can be predicted with accuracy, less cash will be

maintained for an emergency. The amount of precautionary cash is also

influenced by the firms ability to borrow at short notice when the need arises.

Stronger the ability of the firm to borrow at short notice, less the need for

precautionary balance. The precautionary balance may be kept in cash and

marketable securities.

Speculative Motive

The speculative motive relates to the holding of cash for investing in profit-

making opportunities as and when they arise. The opportunity to make profit

may arise when the security prices change. The firm will hold cash, when it is

expected that the interest rates will rise and security prices will fall. Securities

can be purchased when the interest rate is expected to fall; the firm will benefit

by the subsequent fall in interest rates and increase in security prices. The firm

may also speculate on materials prices.

Cash Management

Although cash is only 1-3% of total current assets but its management is very

important.

Management of cash includes:

Determination of optimum amount of cash required in the business.

To keep the cash balance at optimum level and investment of

surplus cash in profitable manner.

Prompt collection of cash from receivables and efficient

disbursement of cash.

Cash management is concerned with the managing of: (i) cash flows into

and out of the firm, (ii) cash flows within the firm, and (iii) cash balances held

by the firm at a point of time by financing deficit or investing surplus cash.

Sales generate cash which has to be disbursed out. The surplus cash has to be

invested while deficit has to be borrowed. Cash management seeks to

accomplish this cycle at a minimum cost. At the same time, it also seeks to

achieve liquidity and control. Cash management assumes more importance than

other current assets because cash is the most significant and the least productive

asset that a firm holds. It is significant because it is used to pay the firms

obligations. However, cash is unproductive. Unlike fixed assets or inventories,

it does not produce goods for sale. Therefore, the aim of cash management is to

maintain adequate control over cash position to keep the firm sufficiently liquid

and to use excess cash in some profitable way.

Cash management is also important because it is difficult to predict cash

flows accurately, particularly the inflows, and there is no perfect coincidence

between the inflows and outflows of cash. During some periods, cash outflows

will exceed cash inflows, because payment of taxes, dividends, or seasonal

inventory builds up. At other times, cash inflow will be more than cash

payments because there may be large cash sales and debtors may be realized in

large sums promptly. Further, cash management is significant because cash

constitutes the smallest portion of the total current assets, yet managements

considerable time is devoted in managing it. In recent past, a number of

innovations have been done in cash management techniques. An obvious aim of

the firm these days is to manage its cash affairs in such a way as to keep cash

balance at a minimum level and to invest the surplus cash in profitable

investment opportunities.

In order to resolve the uncertainty about cash flow prediction and lack of

synchronization between cash receipts and payments, the firm should develop

appropriate strategies for cash management. The firm should evolve strategies

regarding the following four facets of cash management:

Optimum Utilisation of Operating Cash

Implementation of a sound cash management programme is based on rapid

generation, efficient utilisation and effective conversation of its cash resources.

Cash flow is a circle. The quantum and speed of the flow can be regulated

through prudent financial planning facilitating the running of business with the

minimum cash balance. This can be achieved by making a proper analysis of

operative cash flow cycle along with efficient management of working capital.

Cash Forecasting

Cash forecasting is backbone of cash planning. It forewarns a business

regarding expected cash problems, which it may encounter, thus assisting it to

regulate further cash flow movements. Lack of cash planning results in

spasmodic cash flows.

Cash Management Techniques:

Every business is interested in accelerating its cash collections and

decelerating cash payments so as to exploit its scarce cash resources to the

maximum. There are techniques in the cash management which a business to

achieve this objective.

Liquidity Analysis:

The importance of liquidity in a business cannot be over emphasized. If one

does the autopsies of the businesses that failed, he would find that the major

reason for the failure was their inability to remain liquid. Liquidity has an

intimate relationship with efficient utilisation of cash. It helps in the attainment

of optimum level of liquidity.

Profitable Deployment of Surplus Funds

Due to non-synchronization of ash inflows and cash outflows the surplus

cash may arise at certain points of time. If this cash surplus is deployed

judiciously cash management will itself become a profit centre. However,

much depends on the quantum of cash surplus and acceptability of market for

its short-term investments.

Economical Borrowings

Another product of non-synchronisation of cash inflows and cash outflows is

emergence of deficits at various points of time. A business has to raise funds to

the extent and for the period of deficits. Raising of funds at minimum cost is

one of the important facets of cash management. The ideal cash management

system will depend on the firms products, organization structure,

competition, culture and options available. The task is complex, and decisions

taken can affect important areas of the firm. For example, to improve

collections if the credit period is reduced, it may affect sales. However, in

certain cases, even without fundamental changes, it is possible to significantly

reduce cost of cash management system by choosing a right bank and

controlling the collections properly.

CASH PLANNING

Cash flows are inseparable parts of the business operations of firms. A firm

needs cash to invest in inventory, receivable and fixed assets and to make

payment for operating expenses in order to maintain growth in sales and

earnings. It is possible that firm may be taking adequate profits, but may suffer

from the shortage of cash as its growing needs may be consuming cash very

fast. The cash poor position of the firm can be corrected if its cash needs

are planned in advance. At times, a firm can have excess cash with it if its cash

inflows exceed cash outflows. Such excess cash may remain idle. Again, such

excess cash flows can be anticipated and properly invested if cash planning is

resorted to. Cash planning is a technique to plan and control the use of cash.

It helps to anticipate the future cash flows and 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).

Cash planning protects the financial condition of the firm by developing a

projected cash statement from a forecast of expected cash inflows and

outflows for a given period. The forecasts may be based on the present

operations or the anticipated future operations. Cash plans are very crucial in

developing the operating plans of the firm.

Cash planning can be done on daily, weekly or monthly basis. The period

and frequency of cash planning generally depends upon the size of the firm

and philosophy of management. Large firms prepare daily and weekly

forecasts. Medium-size firms usually prepare weekly and monthly forecasts.

Small firms may not prepare formal cash forecasts because of the non

availability of information and small-scale operations. But, if the small firm

prepares cash projections, it is done on monthly basis.

Cash Management involves the following 4 problems

1.Controlling the level of cash

2.Controlling the level of inflow of cash

3.Controlling the level of outflow of cash

4.Optimum investment of surplus cash

Controlling the level of cash

The Level of cash locked up in the cash balances should be only that

amount which is required.

This is achieved by preparing what is called the Cash Budget

Cash budget is the cash forecast which involves the future projection of

the cash receipts as well as the cash disbursement.

Cash Budgeting and Forecasting 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. This information helps the financial

manager to determine the future cash needs of the firm, plan for the financing

of these needs and exercise control over the cash and liquidity of the firm.

The time horizon of the cash budget may differ from firm to firm. A firm

whose business is affected by seasonal variations may prepare monthly cash

budgets. Daily or weekly cash budgets should be prepared for determining

cash requirements if cash flows show extreme fluctuations. Cash budgets for a

longer intervals may be prepared if cash flows are relatively stable.

Cash Forecasting Cash forecasts are needed to prepare cash budgets. Cash forecasting may be

done on short or long-term basis. Generally, forecasts covering periods of one

year or less are considered short term ;those exceeding beyond one year are

considered long term.

Short-term Cash Forecasts It is comparatively easy to make short-term cash forecasts. The important

functions of carefully

developed short-term cash forecasts are:

To determine operating cash requirements

To anticipate short-term financing

To manage investment of surplus cash.

The short-term forecast helps in determining the cash requirements for

a predetermined period to run a business. If the cash requirements are not

determined, it would not be possible for the management to know-how much

cash balance is to be kept in hand, to what extent bank financing be depended

upon and whether surplus funds would be available to invest in marketable

securities.

To know the operating cash requirements, cash flow projections have

to be made by a firm. As stated earlier, there is hardly a perfect matching

between cash inflows and outflows. With the short-term cash forecasts,

however, the financial manager is enabled to adjust these differences in favour

of the firm.

It is well known that, for their temporary financing needs, most

companies depend upon banks. One of the significant roles of the short-term

forecasts is to pinpoint when the money will be needed and when it can be

repaid. With such forecasts in hand, it will not be difficult for the financial

manager to negotiate short-term financing arrangements with banks. This in fact

convinces bankers about the ability of the management to run its business.

The third function of the short-term cash forecasts is to help in

managing the investment of surplus cash in marketable securities. Carefully and

skill fully designed cash forecast helps a firm to: (i) select securities with

appropriate maturities and reasonable risk, (ii) avoid over and under investing

and (iii) maximize profits by investing idle money.

Short-run cash forecasts serve many other purposes. For example,

multi-divisional firms use them as a tool to coordinate the flow of funds

between their various divisions as well as to make financing arrangements for

these operations. These forecasts may also be useful in determining the margins

or minimum balances to be maintained with banks. Still other uses of these

forecasts are:

Planning reductions of short and long-term debt

Scheduling payments in connection with capital expenditures

programmes

Planning forward purchases of inventories

Checking accuracy of long-range cash forecasts

Taking advantage of cash discounts offered by suppliers

Guiding credit policies.

Short-term Forecasting Methods

Two most commonly used methods of short-term cash forecasting are:

1. The receipt and disbursements method

2. The adjusted net income method.

The receipts and disbursements method is generally employed to

forecast for limited periods, such as a week or a month. The adjusted net income

method, on the other hand, is preferred for longer durations ranging between

few months to a year. Both methods have their pros and cons. The cash flows

can be compared with budgeted income and expenses items if the receipts and

disbursements approach is followed. On the other hand, the adjusted income

approach is appropriate in showing a companys working capital and future

financing needs.

Receipts and disbursements method: Cash flows in and out in most

companies on a continuous basis. The prime aim of receipts and disbursements

forecasts is to summarize these flows during a predetermined period. In case of

those companies where each item of income and expense involves flow of cash,

this method is favoured to keep a close control over cash.

Three broad sources of cash inflows can be identified: (i) operating,

(ii) non-operating, and (iii) financial. Cash sales and collection from customers

form the most important part of the operating cash inflows. Developing a sales

forecast is the first step in preparing cash forecast. All precautions should be

taken to forecast sales as accurately as possible. In case of cash sales, cash is

received at the time of sale. On the other hand, cash is realized after sometime if

sale is on credit. The time realizing cash on credit sales depends upon the firms

credit policy reflected in the average collection period.

It can easily be noted that cash receipts from sales will be affected by

changes in sales volume and the firms credit policy. To develop a realistic cash

budget, these changes should be accounted for. If the demand for the firms

products slackens, sales will fall and the average collection period is likely to be

longer which increases the chances of bad debts. In preparing cash budget,

account should be taken of sales discounts, returns and allowances and bad

debts as they reduce the amount of cash collections from debtors.

Non-operating cash inflows include sale of old assets and dividend

and interest income. The magnitude of these items is generally small. When

internally generated cash flows are not sufficient, the firm escorts to external

sources. Borrowings and issuance of securities are external financial sources.

These constitute financial cash inflows.

The next step in the preparation of a cash budget is the estimate of

cash outflows. Cash outflows include: (i) operating outflows: cash purchases,

payment of payables, advances to suppliers, wages and salaries and other

operating expenses, (ii) capital expenditures, (iii) contractual payments:

repayment of loan and interest and tax payments; and (iv) discretionary

payments: ordinary and preference dividend. In case of credit purchases, a time

lag will exist for cash payments. This will depend on the credit terms offered by

the suppliers.

It is relatively easy to predict the expenses of the firm over short run.

Firms usually prepare capital expenditure budgets; therefore, capital

expenditures are predictable for the purposes of cash budget. Similarly,

payments of dividend do not fluctuate widely and are paid on specific dates.

Cash out flow can also occur when the firm repays its long-term debt. Such

payments are generally planned and, therefore, there is no difficulty in

predicting them.

Once the forecasts for cash receipts and payments have been

developed, they can be combined to obtain the net cash inflow or outflow for

each month. The net balance for each month would indicate whether the firm

has excess cash or deficit. The peak cash requirements would also be indicated.

If the firm has the policy of maintaining some minimum cash balance,

arrangements must be made to maintain this minimum balance in periods of

deficit. The cash deficit can be met by borrowings from banks. Alternatively,

the firm can delay its capital expenditures or payments to creditors or postpone

payment of dividends.

One of the significant advantages of cash budget is to determine the

net cash inflow or out flow so that the firm is enabled to arrange finances.

However, the firms decision for appropriate sources of financing should

depend upon factors such as cost and risk. Cash budget helps a firm to manage

its cash position. It also helps to utilize ideal funds in better ways. On the basis

of cash budget, the firm can decide to invest surplus cash in marketable

securities and earn profits.

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: This method of cash forecasting

involves the tracing of working capital flows. It is sometimes called the sources

and uses approach. Two objectives of the adjusted net income approach are: (i)

to project the companys need for cash at a future date and (ii) to show whether

the company can generate the required funds internally, and if not, how much

will have to be borrowed or raised in the capital market.

As regards the form and content of the adjusted net income forecast, it

resembles the cash flow statement discussed previously. It is, in fact a projected

cash flow statement based on performance financial statements. It generally has

three sections: sources of cash, uses of cash and the adjusted cash balance. This

procedure helps in adjusting estimated earnings on an accrual basis to a cash

basis. It also helps in anticipating the working capital movements.

In preparing the adjusted net income forecasts items such as net

income, depreciation, taxes, dividends etc., can easily be determined from the

companys annual operating budget. Normally, difficulty is faced in estimating

working capital changes; especially the estimates of accounts receivable

(debtors) and inventory pose problem because they are influenced by factors

such as fluctuations in raw material costs, changing demand for the companys

products and possible delays in collections. Any error in predicting these items

can make the reliability of forecast doubtful.

One popularly used method of projecting working capital is to use

ratios relating accounts receivable and inventory to sales. For example, if the

past experience tells that accounts receivable of a company range between 32

percent to 36 percent of sales, an average rate of 34 percent can be used. The

difference between the projected figure and that on the books will indicate the

expected increase or decrease in cash attributable to receivable.

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 s 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.

Long-term Cash Forecasting

Long-term cash forecasts are prepared to give an idea of the

companys financial requirements in the distant future. They are not as detailed

as the short-term forecasts are. Once a company has developed long-term cash

forecast, it can be used to evaluate the impact of, say, new product

developments or plant acquisitions on the firms financial condition three, five,

or more years in the future. 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.

Long-term cash forecasts may be made for two, three or five years. As

with the short-term forecasts, companys practices may differ on the duration of

long-term forecasts to suit their particular needs.

The short-term forecasting methods, i.e., the receipts and

disbursements method and the adjusted net income method, can also be used in

long-term cash forecasting. Long-term cash forecasting reflects the impact of

growth, expansion or acquisitions; it also indicates financing problems arising

from these developments.

Controlling The Cash Inflows After preparing the cash budget the finance manager should ensure that

there is no deviation in the inflow of the cash .

Any deviation from the expected cash inflow can lead to upsetting of the

whole budget activity.

The Finance manager needs to devise appropriate techniques so that the

cash coming to the firm should not get diverted to anywhere else.

The cash should also come on time.

Designing a Collection System:-

Numbers of collection points

Location of Collection point

Internal and external operations of collection point

Assignment of individual payers to collection point

Capture and movement of information's about the payment

Optimizing collection system Reducing floats costs by speedy availability of cash in banking system

Reducing operating cost of collection system

Reducing operating cost of managing the system

Reducing mail floats

Reducing processing floats

Reducing availability floats

Types of collection systems Over the counter collection

It is the system where the payment is received in face to face meeting the

customers. Mostly retail or customer business receive full or at least some part

of their payments on the over the counter basis. Since payments are not mailed,

an over the counter system does not contain mail float.

Basic Components

It includes the field unit at which the payment is received, a local deposit

bank that serve as the entry point for the firms banking system and an input into

the firms central information system.

Mailed payment collection system Many companies receive payments through cheques mailed by customers in

response to an invoice. A mailed payment system contains all three components

of collection float i.e. mail float, processing float, float & availability float.

Basic Components

It consists of collection centers, deposit banks and an information system.

Payments are mailed by customers to a designated collection centre operated by

company or by an outside agent. Payments are processed at collection centre;

cheques are encoded; the deposit is prepared and made and the data are

transmitted to the companies information system.

Techniques for controlling the Cash Inflow.

1. Concentration Banking Decentralized system of account receivables, for the firms having their

operations spread over a large geographical area.

The firm establishes a large number of collection centres in different

geographical areas.

The collection centres deposit the cheques from the debtors to the local

branch of the bank.

The local bank transfers a certain amount of money on daily basis to the

Bank at Head office.

This results in the faster collection of the funds.

2.Lock Box System A further step in speeding up of the collection of cash. In case of

concentration banking the cheques are received by the collection centres and

then deposited in the bank by the collection centres.

While in Lock Box System the firm hires the PO boxes and gives the

authority to the bank to pick the remittances directly from the lock box and

deposit in the forms account directly.

This reduces the gap further in the collection of check and the deposit of the

check.

The bank picks up the mail several times daily and deposit the cheques in

the firms account.

Controlling The Cash Outflow

This relates to the cash payment to be given to the creditors.

Here the aim is totally opposite to what one has in controlling the cash

inflow.

Here we want to delay the payment as much as possible and thus want to

slowdown the process.

The combination of the faster collection and slow disbursement leads to

maximum availability of funds.

Disbursement

It includes the banks, delivery mechanism and procedures the firms used

to facilitate the movement of cash from the firms centralized cash pool

to disbursement banks and then suppliers.

Disbursement banks are bank upon which disbursement cheques are

drawn.

The concentration bank serve as value between firms collection system,

liquidity portfolio and disbursement bank.

Objective of Disbursement System:-

Maximum value of disbursement floats.

Minimum loss of discount for early payment.

Minimum transaction cost, Information costs, Administration cost &

control costs.

Maximum Value of Payee relation.

Centralized disbursement.

Disbursement Tools

1. Zero Balance System :

It is the common strategy for funding disbursement as the cheques are

presented. In this strategy an account for disbursement is first established at a

bank. For the effectiveness, the participatory bank must be one on which most

disbursements are made via the clearance system ( only in the morning) and not

the bank where disbursement occurs throughout the day. The banks used in zero

balance strategies are usually branches of major banks but not at the main

locations.

As implied by name firm dont Keep any permanent stock of cash in this

account. Instead the participatory bank agrees that when the morning

disbursement for firm presented to it, bank will advise to the firm of the amount

of cash required to these disbursements. The money will then be wire

transferred into the zero balance account and the cheques will be honored. In

this way the disbursing firms cheques are honored as they are presented, but

the firm does not tie up cash while the cheques are in mail and while they are

clearing.

2.Controlled Disbursement:-

If the zero balance system is not feasible, an other is the use of controlled

disbursement which is often used when the firms disbursement bank receives

cheques for clearance throughout the day. In this system, the firm projects the

amount of cheques to arrive each day at the disbursement bank and transfers the

amount of expected cheques to the account on that day or just before. Of course,

the firm does not know what outstanding cheques will be presented on any

particular day; to hedge the uncertainty the firm keeps a safety stock of cash in

this account. The amount of safety stock may be calculated if the probability

distribution of disbursement is known.

Optimum Investment of The Funds

One of the primary responsibilities of the financial manager is to maintain a

sound liquidity position of the firm so that the dues are settled in time. The firm

needs cash to purchase raw materials and pay wages and other expenses as well

as for paying dividend, interest and taxes. The test of liquidity is the availability

of cash to meet the firms obligations when they become due.

A firm maintains the operating cash balance for transaction purposes. It may

also carry additional cash as a buffer or safety stock. The amount of cash

balance will depend on the risk return trade-off. If the firm maintains small cash

balance, its liquidity position weakens, but its profitability improves as the

released funds can be invested in profitable opportunities (marketable

securities). When the firm needs cash, it can sell its marketable securities (or

borrow). On the other hand, if the firm keeps high balance, it will have a strong

liquidity position but its profitability will be low. The potential profit foregone

on holding large cash balance is an opportunity cost to the firm. The firm should

maintain- just enough, neither too much nor too little- cash balance. How to

determine optimum cash balance if cash flows are predictable and if they are

not predictable?

There are 2 problems that the firm face while taking the decision to invest

the surplus cash:-

1. Where to invest:-

o Which type of security,

o For how much time,

o Liquidity, etc

2. Determine the amount of surplus cash in hand

o The cash in excess of what is considered the normal cash requirement

of the firm is called the excess cash.

o So FM needs to know what is the normal cash requirement

o This normal cash requirement is also called the safety level of cash

o How to determine this safety level of cash?

Models to determine the optimum level of cash

Optimum Cash Balance under Certainty:

Baumols Model:-

The Baumol model of cash management provides a formal approach for

determining a firms optimum cash balance under certainty. It considers cash

management similar to an inventory management problem. As such, the firm

attempts to minimize the sum of the cost of holding cash (inventory of cash) and

the cost of converting marketable securities to cash.

The Baumols model makes the following assumptions:

o The firm is able to forecast its cash needs with certainty.

o The firms cash payments occur uniformly over a period of time.

o The opportunity cost of holding cash is known and it does not change

over time.

o The firm will incur the same transaction cost whenever it converts

securities to cash.

Let us assume that the firm sells securities and starts with a cash balance of C

rupees. As the firm spends cash, its cash balance decreases steadily and reaches to

zero. The firm replenishes its cash balance to C rupees by selling marketable

securities. This pattern continues over time. Since the cash balance decreases

steadily, the average cash balance will be: C/2.

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:

Holding cost = k(C/2) (1)

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:

Transaction cost = c(T/C) (2)

The total annual cost of the demand for cash will be:

Total cost = k(C/2) + c(T/C) (3)

What is the optimum level of cash balance, C*? We know that the holding cost

increases as the demand for cash, C, increases. However, the transaction cost

reduces because with increasing C the number of transactions will decline.

Thus, there is a trade-off between the holding cost and the transaction cost.

The optimum cash balance, C*, is obtained when the total cost is minimum. The

formula for the optimum cash balance is as follows:

C* = 2cT/k (4)

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 per

transaction cost and total funds required and decrease with the opportunity cost.

Optimum Cash Balance under Uncertainty:

2. The Miller-Orr Model

The limitation of the Baumol model is that it does not allow the cash flows to

fluctuate. Firms in practice do not use their cash balance uniformly nor are they

able to predict daily cash inflows and outflows. The Miller-Orr (MO) model

overcomes this shortcoming and allows for daily cash flow variation. It assumes

that net cash flows are normally distributed with a zero value of mean and

standard deviation. The MO model provides for two control limitsthe upper

control limit and the lower control limit as well as a return point. If the firms

cash flows fluctuate randomly and hit the upper limit, then it buys sufficient

marketable securities to come back to a normal level of cash balance (the return

point). Similarly, when the firms cash flows wander and hit the lower limit, it

sells sufficient marketable securities to bring the cash balance back to the

normal level (the return point).

The firm sets the lower control limit as per its requirement of maintaining

minimum cash balance. At what distance the upper control limit will be set?

The difference between the upper limit and the lower limit depends on the

following factors:

The transaction cost (c)

The interest rate, (i)

The standard deviation of net cash flows.

The formula for determining the distance between upper and lower control

limits (called Z) is as follows:

(Upper LimitLower Limit) = (3/4 * transaction cost * cash flow variation/

interest per day) (5)

We can notice from equation (5) that the upper and lower limit 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 increases.

Z is inversely related to the interest rate. It is noticeable that the upper limit is

three times above the lower control limit and the return point lies between the

upper and the lower limit. Thus,

Upper Limit = Lower Limit + 3Z (6)

Return point = Lower Limit + Z (7)

The net effect is that the firms hold the average cash balance equal to:

Average Cash Balance = Lower Limit +4/3 Z

The MO model is more realistic since it allows variation in cash balance within

lower and upper limits. The financial manager can set the lower limit according

to the firms liquidity requirement. The past data of the cash flow behavior can

be used to determine the standard deviation of net cash flows. Once the upper

and lower limits are set, managerial attention is needed only if the cash balance

deviates from the limits. The action under these situations are anticipated and

planned in the beginning.

Case Study Cash management services by SBI

State Bank is highly recognized as a leading cash management supplier

across the emerging markets.

With SBI, one always have the flexibility to manage his company's

complete financial position directly from his computer workstation.

STATE BANK OF INDIA provides cash management services to

Corporate Clients under the brand name SBI FAST(Funds Available in

Shortest Time).

SBI FAST:-

SBI FAST ensures optimization of collections and payouts while

ensuring predictability in the cash flows.

SBI FAST ensures getting Funds in time, quick transfers, account

reconciliation, easy disbursements, controlled processes and customized

MIS.

SBI FAST eliminates the inherent delays of the traditional funds transfer

mechanism and enhances liquidity to ensure optimum planning and

utilization of funds.

SBI FAST also offers File upload facility on its web based portal and

provides complete Host to Host facility (a secure, seamless file transfer

facility).

Three services provided are:-

Payment Services

Collection Services

Liquidity Management

Payment Services o SBI provide global payments solution for efficient transaction

processing.

o Efficient processing of all your payables in the most cost

effective way.

o Straight through processing both at your end as well as your

bank's back-end.

o Efficient payables reconciliation with minimal effort and delay.

o Quick approval of payments from any location.

o Minimum hindrance to automation due to local language

difficulties.

Payment System:-

o State Bank's Straight Through Services (STS) Payments Solution is used

to accomplish the different payment needs of companies.

o It is performed by allowing information that has been electronically

entered to be transferred from one party to another in the settlement

process without manually re-entering the same pieces of information

repeatedly over the entire sequence of events.

o STS allows companies to process a variety of payment types, whether

they be domestic or international, local or central in different countries,

all in a single system file.

o To realise the benefits of STS, one has to contact its local Relationship

Manager or Cash Management representative.

Tools for Payment:-

Real Time Gross Settlement

1. Inter Bank Product - Settlement through RBI.

2. Minimum Transaction Amount Rs.2.0 lac.

3. Settlement on the day of transaction .

National Electronic Fund Transfer

1. Inter Bank Product - Settlement through RBI.

2. Used for amount less than Rs.2.0 lac.

3. Settlement on the same day or next day.

Electronic Clearing Scheme

1. Electronic mode of payment at all 72 ECS centres and across India

through NECS for banks on corp. Banking.

2. Useful for payment of interest, dividend, salary, pension to a large

number of investors/ share holders/ employees/ ex-employees.

Direct Credit

1. Intra-Bank of SBI for electronic payment that uses ' Core Power '.

2. Settlement online & available between CBS branches (Over 12,500 &

growing).

DRAFTS

1. Meets Bulk Drafts requirement on day '0'.

2. Facsimile signature enabled up to Rs.5.0 lacs.

3. Printed with forwarding letter also.

Multi City Cheques

1. Client's facsimile signatures affixed for amount up to Rs.5 lacs.

2. Printed with customized forwarding letter.

3. Provision for direct despatch to the beneficiary.

Collection System The State Bank Collections Solution leverages the Bank's extensive

regional knowledge and widespread branch network across the key

markets to specially tailor solutions for your regional and local collection

needs.

The key components of their solution include the following:

o Extensive Clearing Network

o Guaranteed Credit

o Comprehensive MIS

o System Integration

o Outsourcing of Collection

o Liquidity Management

Collection Tools o LOCAL COLLECTIONS: (Cheques/ drafts etc.)

Collection of instruments tendered at various CMP collection centres.

Depending on the clearing practices prevailing at the various centres (i.e.

Day-0, Day-1, or Day-2), credit is afforded, as mandated, to the client's

main account at the pooling centre the same day as the proceeds are

cleared.

o OUTSTATION CHEQUES COLLECTION:

Outstation Cheques can also be deposited at CMP Cell branches and we

afford Guaranteed

Credit facility with credit available on Day 1 to Day 7.

o CASH COLLECTION:

SBI also offer the facility of Cash Deposit at CMP Cell branches on

CMP software which facilitates automatic pooling of funds with MIS.

Cash pick up facility from clients end available at most major centres.

o UNCLEARED FUNDS:

Option of credit against Unclear Instruments presented in

General/MICR or High Value clearing offered selectively at Bank's

discretion.

A nominal limit is required to be set up to take care of returns.

o BALANCE SWEEP:

Transfer of day-end-balances in collection accounts maintained at

various CMP centres across the country to the pooling account.

Clients can use the account for crediting local and outstation

collections as well as for meeting payments and the residual balance at

the end of the day swept to the main account.

o DEBIT TRANSFERS:

Debit Balances in operating accounts, where withdrawals are

permitted up to a pre-fixed daylight limit, maintained at CMP centres

transferred to the main account at the end of the day.

The facility dispenses the use of allocated limits and thereby ensures

better control, for the client over debits.

Liquidity Management

Through its liquidity management services SBI:-

Maximise interest income on surplus balances.

Minimise interest expense on deficit balances for domestic, regional and

global accounts.

Minimise FX conversion for cross-currency cash concentration.

Customise liquidity management solutions for different entities in

different countries.

Centralise information management of consolidated account balances.

Key Techniques Offered

1.Physical Sweeping

Physical sweeping is the movement of cash from multiple bank accounts

into a single concentration account.

This is typically accomplished with a zero-balance account, from which a

bank automatically sweeps all cash at the end of the day, and into a

concentration account.

If the zero-balance account has a debit balance at the time of the sweep,

then the funds are shifted from the concentration account back into the

account having the debit balance, until its balance is zero.

2.Notional Pooling:-

Notional Pooling is a cash management service, enabling a company

or a group of companies to obtain better interest conditions by

virtually offsetting credit and debit balances.

It allows each subsidiary company to take advantage of a single,

centralized liquidity position, while still retaining daily cash

management privileges.

There are no bank fees related to cash transfers, since there are no

transfers between accounts that would normally trigger fees.

Trends in Cash Management The Drive Towards Efficiency, Transparency,

standardization and Integration

Payments Convergence

Trends Towards Electronics

Increasing Payment Alternatives for Consumers

Accelerating Momentum for Corporate Payments

Towards Strategic Receivables Management

The Convergence of Cash, Trade, Liquidity and Risk

References

Corporate Treasury and Cash Management (Finance

and Capital Markets Series)

The Strategic Treasurer: A Partnership for Corporate

Growth

International Cash Management (Treasury )