CASH MANAGEMENT
CHAPTER
24

CONTENTS
 Introduction
 Motives for Holding Cash
 Cash Flow Process and its Relevance
 Principles of Cash Management
 Collection and Disbursement Management
 Collection Float and its Impact on Profitability
 Cash Forecasting
 Cash vs. Marketable Securities
 Baumol Model
 Miller-Orr Model
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INTRODUCTION
 Cash is the most liquid but least productive
current asset.
 The higher the cash in hand and bank
balance, the stronger is the liquidity position.
 But the funds tied up in cash in hand and in
current accounts of banks give a yield of zero.
 The determination of optimal cash balance
assumes importance, as it affects the
profitability–liquidity position of the firm.
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INTRODUCTION
 Maximizing cash availability while simultaneously
minimizing idle cash is the thrust of cash
management.
 The two seemingly contradictory objectives of cash
management-maximizing the cash availability and
also the interest income-can be achieved through:
 Managing collections and disbursements
 Reliable forecasting and reporting systems
 Maximizing interest income by selecting the
optimal mix of cash (held for transaction
requirements) and marketable securities.
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MOTIVES FOR HOLDING
CASH
 Transactionary motive
 Precautionary-motive
 Speculative-motive
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CASH FLOW PROCESS AND ITS
RELEVANCE
 Cash is the lifeblood of a business.
 Lack of a perfect synchronization of inflows and
outflows make cash management important.
 In cases where the inflows precede the outflows,
the issue of productively parking the idle cash is of
importance to the firms.
 When the outflows precede the operating inflows,
the business has to have a sufficient cash buffer to
ensure that it is able to meet outflow requirements.
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CASH FLOW PROCESS AND ITS
RELEVANCE
 The operating cash flows are of utmost importance from
the working capital perspective.
 The cash flow surplus from operating activities
determines liquidity health and sustainability of
operations.
 This surplus also contributes towards capital servicing and
future financing needs. Hence, its management assumes
significance for the business.
 Potentially profitable companies can fail because of poor
cash management, while apparently non-profitable
companies can be kept alive by efficient cash
management techniques.
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PRINCIPLES OF CASH MANAGEMENT
 The two prime objectives for the firm’s cash
management system are:
 Holding enough cash balance to carry out the
operating needs of the business.
 Minimizing funds tied up in the idle cash
balance.
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PRINCIPLES OF CASH MANAGEMENT
 To achieve these twin objectives, the
firms need to focus on the following
three important aspects of cash
management:
 Managing collections and disbursements
 Reliable forecasting and reporting system
 Maximizing the interest income by selecting
the optimal mix of cash and marketable
securities.
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COLLECTIONS AND DISBURSEMENTS
MANAGEMENT
 Cash management focuses prominently on
maximizing the availability of cash through quick
collections and slow disbursements.
 Quick collection helps the firms not only in
shortening their working capital cycle but also
in reducing their collection float.
 To ensure quick collections the firm should take
the entry points closer to the customers.
 It is important to convert the collected funds
into usable funds as quickly as possible.
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COLLECTIONS AND DISBURSEMENTS
MANAGEMENT
 For this the firm should reduce the
internal processing float, and transfer the
collected funds into centralized pool
quickly.
 To maximize the availability of collected
funds firms should try to delay
disbursements up to the point it does not
adversely affect relationships with
suppliers.
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CASH FORECASTING
 A reliable system of cash forecasting helps in
identifying the amounts of cash surpluses and
deficits along with the periods in which they fall.
 This facilitates proper resource planning.
 An accurate forecasting system forms the
bedrock of effective cash management, as cash
forecasting involves projections of all possible
cash flows expected during the forecast periods.
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CASH FORECASTING
 Cash forecasting is an integrated exercise that
requires information from different sources/
departments.
 The starting point of cash forecasting is the
sales projections.
 In the light of these projected sales, the other
departments like production, marketing, and
personnel prepare their respective budgets,
which are eventually integrated into the
overall cash forecast for the firm.
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CASH FORECASTING
 The time horizon for forecasting may range from
one day to one year, depending upon the
requirements.
 Both short-duration and long-duration forecasts
should correspond with each other.
 The process of moving from forecasts of shorter
duration to those of longer duration is known as
scheduling, while the process of moving from
long-duration forecasts to short-duration
forecasts is known as distribution.
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CASH VS MARKETABLE SECURITIES
 Determining the optimal cash balance
assumes significance as cash is the most
liquid but least productive current asset.
 The key issue is to determine the mix of
cash held as working balance and cash
invested in marketable securities.
 A high level of working balance reduces
the transaction costs but increases the
opportunity cost.
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CASH VS MARKETABLE SECURITIES
 The issue of optimal level of working balance is
resolved in the light of tradeoff of opportunity
costs and transaction costs.
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CASH VS MARKETABLE
SECURITIES - MODELS
 The models to determine the optimal
working balance of a firm can be classified
into two categories—certainty-based
models and uncertainty-based models.
 Certainty-based models follow the EOQ
approach of inventory management while
uncertainty-based models follow the
stochastic modeling.
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BAUMOL MODEL
 Baumol Model uses the EOQ method of inventory
control to determine the optimal level of working
balance under conditions of uncertainty.
 Like the EOQ model, the objective function of the
Baumol model is of cost minimization.
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BAUMOL MODEL
 The objective function is to minimize
the total cost. This will be done at the
point where the opportunity cost is
equal to the transaction cost.
 As per the model the optimal working
balance (C) can be calculated as:
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K
bT
2
C 
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MILLER-ORR MODEL
 The Miller–Orr model adopts the stochastic approach
to decisions regarding the optimal working balance.
 Following the control limits approach, the Miller–Orr
model provides two control limits
 the upper control limit,
 the lower control limit, and
 a return point.
 The firm’s cash balance is allowed to fluctuate
between the upper control limit and the lower control
limit.
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MILLER-ORR MODEL
 No transaction is needed, as per the model, till
the cash balance fluctuates between the upper
control limit and the lower control limit.
 Purchase or sale of marketable securities takes
place only when one of these limits is reached.
 The Return Point (R) is calculated as follows:
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3
2
K
4
bs
3
L
Point)
(Return
R 

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MILLER-ORR MODEL
 The Lower Control Limit (L) is set by the
management based on the past cash flow
pattern and expected future requirements.
 The upper control limit (H) is defined as follows:
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L
R
3
)
Limit
Control
Upper
(
H 

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MILLER-ORR MODEL
GRAPHICAL VIEW
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MILLER-ORR MODEL
 As can be seen in the previous figure, when the
firm’s cash flow touches the lower limit on day t2,
disinvestment of marketable securities takes place
to the tune of (R-L).
 Such a transaction brings the cash balance of the
firm back to the normal level, i.e., the Return Point
(R).
 Similarly, when the firm’s cash balance touches the
upper limit on day t5, the firm undertakes
investment transactions and buys marketable
securities to the tune of (H-R).
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MILLER-ORR MODEL
 Such investment transactions bring the firm
back to a normal level of cash balance, i.e.,
the Return Point (R).
 For the rest of the days no investment or
disinvestment transaction gets triggered, as
the firm’s working balance is within the upper
and the lower control limits.
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