Cash management is a broad term that refers to the collection, concentration and disbursement of cash. It encompasses a firm’s level of liquidity, its management of cash balance and its short-term investment strategies. In some ways, managing cash flow is the most important job of a finance manager.

If at any time, the firm fails to pay an obligation when it is due because of lack of cash, the firm is insolvent. Obviously, the prospect of such a dire consequence should compel firms to manage their cash with care.

Moreover, efficient cash management means more than just preventing bankruptcy. It improves the profitability and reduces the risk to which the firm is exposed.

The main objective of cash management is to bring equilibrium between liquidity and profitability of business to maximise its long-term profits. The greater the amount of cash balance, more will be the liquidity of the firm and lesser will be its profitability. 


On the other hand, lesser the amount of cash balance, more will be the profitability and lesser will be the liquidity of business. This is true to a certain limit. After this limit, lesser liquidity will reduce profitability.

Cash management assumes more importance than other current assets because cash is the most significant and the least productive asset that the firm holds. It is significant because it is used to pay firm obligations. 

However, cash is unproductive and as such, the aim of cash management is to maintain an adequate cash position to keep the firm sufficiently liquid to use excess cash in some profitable way.

Management of cash is also important because it is difficult to predict cash flows accurately and that there is no perfect coincidence between inflows and outflows of cash. 


Thus, during some periods, cash outflows exceed cash inflows, because payments for taxes, dividends, excise duty, seasonal inventory buildup, etc. At other times cash inflows will be more than cash payments, because there may be large cash sales and debtors may be realised in large sums promptly.

Cash Management: Meaning, Objectives, Strategies, Importance, Factors, Motives for Holding Cash, Models, Technique, Cash Flows, Cash Budget, Advantages, Problems, Examples and More…

Overview – Cash Management

The term cash is a wider concept even though most of the time it is perceived in a narrow sense. The economic dentition of cash includes currency, savings account deposits at banks, and undeposited cheques. 

However, financial managers often use the term cash to include short- term marketable securities. Short-term marketable securities are frequently referred to as cash equivalents and include Treasury bills, certificates of deposit, and repurchase agreements.

The balance sheet item ‘cash’ usually includes cash equivalents. A highly profitable company might collapse if without adequate cash flow due to the tying up of company’s funds with the accounts receivable and worsened by the needs to make regular payments like wages, rent & utilities, taxes. Therefore managing cash flow is an important task.

Cash Management – Introduction 

The main objective of working capital management is to manage each component of current assets efficiently so that liquidity of the firm could be maintained. The main task in the management of a specific asset is to determine the optimum level of investment in it.


Cash is the most important current asset for the operation of business. Cash is the basis to keep the business going on continuously. It is the most liquid asset. Business should keep adequate cash which should neither be in excess of the requirements nor should it be inadequate.

The shortage of cash can put obstacles in the production process of business and excessive cash will remain useless which will affect the profitability adversely. In any business firm cash does not earn any profits itself. 

Cash is the least productive asset of business. It is important because it is used to pay business liabilities. Therefore, the main objective of cash management is to maintain liquidity at optimum level and to invest surplus cash in profitable manner.


The term ‘cash’ is used in two ways. In the narrow sense, it includes coins, currency notes, cheques, bank drafts, demand deposits, etc. In the wider sense the near cash assets like marketable securities and time deposits are also included in it because they can be converted quickly into cash. In cash management both cash and near cash assets are included.

Cash management is concerned with the management of collection and disbursement of cash, determination of optimum amount of cash and investment of surplus cash.

Cash Management – Meaning of Cash

Cash is the most liquid asset which a firm or an individual holds. By spending this asset, all other assets in the business can be acquired. In other words, cash can be converted into any form of asset. In a narrow sense cash includes coins, currency notes, bank balance and other bank instruments like cheques and bank drafts.

While in a broader sense it also includes near cash assets like time deposits in banks, treasury bills, marketable securities etc. Near cash assets can be converted into cash easily. Cash in a firm can be compared to the blood in a human body. A business firm cannot survive without managing its cash requirement properly. Therefore, it is crucial for the solvency of a business.

What is Cash Management – Meaning

Cash management is a broad term that refers to the collection, concentration and disbursement of cash. It encompasses a firm’s level of liquidity, its management of cash balance and its short-term investment strategies. In some ways, managing cash flow is the most important job of a finance manager.


If at any time, the firm fails to pay an obligation when it is due because of lack of cash, the firm is insolvent. Obviously, the prospect of such a dire consequence should compel firms to manage their cash with care.

Moreover, efficient cash management means more than just preventing bankruptcy. It improves the profitability and reduces the risk to which the firm is exposed.

Nature of Cash Management

The exact nature of cash management would depend upon the organizational structure of a firm. In a highly centralized organization, the system would be such that the central or head office controls the inflows and outflows of cash on a routine and daily basis.


In a decentralized form of organization, where the divisions have complete responsibility for conducting their affairs, it may not be possible and advisable for the central office to exercise a detailed control over cash inflows and outflows.

Objectives of Cash Management

Objectives of Cash Management:

The main objective of cash management is to bring equilibrium between liquidity and profitability of business to maximise its long-term profits. The greater the amount of cash balance, more will be the liquidity of the firm and lesser will be its profitability. 

On the other hand, lesser the amount of cash balance, more will be the profitability and lesser will be the liquidity of business. This is true to a certain limit. After this limit, lesser liquidity will reduce the profitability.


The following are two main objectives of cash Management:

(1) To make payment according to the payment schedule.

(2) To minimise cash balance.

(1) To Make Payment According to Payment Schedule:

One basic objective of cash management is to meet the cash requirements of business i.e., to pay its liabilities in time. In other words, firm needs cash to meet its routine expenses including wages, salary, interest, dividend, taxes, etc.

Following are the main advantages of adequate cash:


(i) It prevents the firm from being insolvent.

(ii) The relation of the firm with bank does not deteriorate.

(iii) It helps the firm to maintain good relations with the suppliers.

(iv) Advantage of trade discount can be taken by making payment in time.

(v) Advantage of favourable business opportunities can be taken

(vi) Contingencies can be met easily.

(2) To Minimise Cash Balance:

The second objective of cash management is to minimise cash balance. In order to minimise cash balance, there is need to co-ordinate two contradictory aspects. Excessive amount of cash balance helps in quicker payments and all advantages relating to such payments can be taken. But it would mean that a large amount of cash funds will remain unused. It will reduce profitability of business.

Contrarily, when cash available with firm is less, the firm is unable to pay its liabilities in time. Therefore, the level of cash in the firm should be optimum. Firm should, therefore, determine its cash requirements considering all the factors affecting such requirement.

Efficient Cash Management

In an efficient cash management, cash at hand and at bank, in spite of all its significance, should be optimum. That is, it should be at a minimum level that will take care of the immediate needs and the contingent requirements of the firm.

For an overall efficient, effective and economical cash management, one needs to emphasise on efficient collections, efficient use of short-term money, discouragement of idle funds, efficient disbursements and monitoring of cash movement from the firm’s bank branch to its headquarter.

Efficient cash management is supported by the fact that the firm develops and uses different sources of short-term money that are flexible enough and readily available at nominal cost.

The firm discourages usable funds (collections or borrowed capital) to stand idle for more than a day.

For profitable and flexible investment of cash, surplus that arises should be profitably invested in marketable securities so that as long as this cash is not required it generates profits, and as soon as it is needed it can be encashed quickly.

Effective cash management involves the following:

i. Efficient collections

ii. Efficient disbursements

iii. Continuous and dynamic monitoring of cash movement.

Collections are the sale receipts received by the firm from its customers by selling its products or services to them. More efficient the collection of the sale proceeds, the more cash the firm has, and the availability of funds increases as collection time decreases.

Efficient collection management can be done by speeding up collections, decentralisation of collection systems, etc. There are two popular decentralised collection systems that speed up cash collection and reduce the float time.

These are as follows:

1. Lockbox System,

2. Concentration Banking.

1. The Lockbox System:

It is a simple method used in reducing collection float and accelerating firm’s collections or remittances. When a firm adopts the lockbox system, it takes a post office box in its name, called lockbox, and requests its customers to mail their payments to these lockboxes.

These lockboxes are attended by local collection banks or local branch or depot personnel one or more times every day (if possible even on holidays). These cheques are deposited directly into the local bank account of the firm. If it is through the local bank, then the company authorises its bank to collect its sale receipts from the lockboxes.

The bank then sends particulars of cheques along with letters or other accompanying materials to the firm for information. After the cheques are realised, surplus funds from the local banks are transferred (usually by wire) to the central account or accounts of the firm.

Thus the lockbox system helps to reduce the mailing time, because cheques are received at a nearby post office instead of at corporate headquarters, and deposited and cleared locally. It also helps in reducing the processing time as the deposits are made by the local bank.

Hence, firm saves on its time and efforts for processing the mails and reduces the availability delay as the firm encourages its customers to draw the cheque on local banks.

In this way, the firm is in a better position to use its collections immediately. This system reduces mail float, clearing float as well as processing float. Banks do charge some fee against these services.

Whenever firms analyse the possibility of adopting such systems, they must evaluate the cost and benefits attached. The benefits derived from the speeding up of collec­tions must be greater than the costs of the lockbox system.

Lockboxes are widely dispersed because they are usually adopted by multinationals, large and big companies, which have their branches in many states.


i. A lockbox system reduces the mail float because lockboxes can be established at different geographical locations and thus reduces mailing time.

ii. To ensure that check processing time is minimised, some banks offering lockbox services pick up and process mail on a continuing basis and process checks on a 24-hour basis.

iii. Another advantage is that the bank performs the clerical work for processing the incoming cheques prior to deposits. In this respect, it is superior to the concentration banking system.

iv. The lockbox system enjoys the additional advantages of eliminating the cheque processing float completely because they do not record the checks until it has been deposited.


The main disadvantage of this system is the cost. The bank will provide a number of additional services, to the usual clearing of cheques.

Accordingly, it will require compensation for the additional services—usually in the form of increased deposits from the firm. Because the cost is almost directly proportional to the number of cheques deposited, this system is not profitable if the average remittance is small.

2. Concentration Banking:

In concentration banking, the company establishes a number of strategic collection centres in different regions instead of a single collection centre at the head office. When the firms open up different collection centres in different parts of the country in order to reduce the postal delays, it is known as concentration banking.

It is one of the important and popular ways of reducing the size of the float. Here the firm requests its customers to mail their payments to a local or regional collection centre instead of mailing it to the head office.

This system reduces the period between the times a customer mails in his remittances and the time when they become spendable funds with the company. Payments received by the different collection centres are deposited with their respective local banks, which in turn transfer all surplus funds to the concentration bank of the head office.

The concentration bank with which the company has its major bank account is generally located at the headquarter.

Surplus funds from the local banks are transferred by mail or wire form the local bank accounts to a concentration bank or banks. The choice between a wire or mail transfer depends on two factors – the amount involved and the cost of finance.

In general, wire transfers are economical only when large sums of money are involved and the firm can earn a reasonable return on short term, low risk and highly liquid investments.


i. It reduces mail float significantly. The customers receive the bills from the collection centres instead of from head office, and secondly when they send their cheques to the collection centres, the mailing time is shorter than the time required for mailing them to the head office.

ii. Average bank float is also reduced. This is mainly because of reduction in the volume of outstation cheques as most of the cheques deposited in the collection centre’s bank are drawn on banks in that area.

iii. This system reduces the time of collection and hence results in better cash management.

iv. Cash concentration improves the control of the firm over inflows and outflows of cash.

v. Disbursing cash from one place becomes easier and efficient.

vi. Cash concentration also reduces idle cash balances.

vii. The balance at regional offices is kept low, which is almost equal to the actual total expenses of the regional branches.

viii. Any excess funds are moved to the concentration bank(s). Excess funds in concentration banks(s) are invested for short-term periods to provide better yields to the firm.

However, cash concentration is encouraged by timely transfer of funds to and from concen­tration banks and regional branches. For efficient fund transfer, firms use cheques and drafts as a payment and receipt mode. The other methods like automated clearing house (ACH), electronic transfer and wire transfer are also used for remitting funds.

The main issue here is selecting the collection centres, which largely depends on the volume of billing/business in a particular geographical area. However, the cost of concentration system is the minimum account balance required to be maintained in these current accounts.

Importance of Cash Management

Sydney Robbins, while emphasising the importance of cash in a business, said “Cash-what a strange commodity! A business wants to get hold of it in the shortest possible time but to keep the least possible quantity on hand. Increased sophistication in the handling of cash has enabled companies to cut down on the balances needed to sustain any given level of operations”.

Cash is the most liquid asset that a business owns. It includes money and such instruments as cheques, money orders or bank drafts which banks normally accept for deposit and immediately credit to the depositor’s account. The main preoccupation of a businessman is cash, which is the starting point and the finishing point.

It is the sole asset at the commencement and the termination of a business. It should be remembered that a want of cash contributes more towards non-existence of a business than any other single factor.

What is required is cash, and, if it is not available, shareholders can only conclude that the financial affairs of the company have been mismanaged, howsoever, satisfactory the balance in the Profit and Loss Account may be.

Cash imparts life and strength-profits and solvency to the business organisation. It should be understood that though firms differ in considerable degree in terms of nature of business, capital structure, personnel employed, risk technology and so on, one thing which they have in common is the basic mechanism involving the conversion of funds into saleable products and back into liquid form.

Cash in its ultimate state yields no returns and as such is barren. The idea that a large bank balance reveals a sound position financially has long since been disproved, leading as it does, to the holding of an asset which is devoid not only of earning power but is on the contrary, expensive to retain an important position in the structure of working capital.

Cash is the beginning as well as the end of the operating cycle of a manufacturing concern. It is the basic input needed to keep the business running on a continuing basis and is also the ultimate output expected to be realised by’ selling the product.

The cash balance of a company is a ‘safety valve’ or shock absorber, protecting the company against short-run fluctuations in funds requirements.

One of the most urgent and important demands confronting the corporate financial management is making the synchronisation of the rates of inflow of receipts with the rates of outflow of cash disbursements.

Planning for cash requirements is an essential management function of any business. It is not enough for an undertaking to make a profit. Cash resources should be planned to finance a cash flow, without which, otherwise efficient and profitable businesses would have encountered financial difficulties.

A corporate financial officer should plan his cash and credit sources in such a way that the normal operations of the corporation are not disrupted by a shortage of cash and that opportunities for capital expenditure are not lost because of the inability to finance them.

The creditworthiness of a business is one of its most valuable assets. A management should, therefore ensure that there are no hold-ups in the payment of its dues because it would earn the reputation of being a bad paymaster, or even more importantly, its creditors may resort to litigation.

Unfortunately, the inflow and outflow of funds cannot be synchronised completely. If this were possible, it would not be necessary to maintain more than a minimum of cash or near cash resources. A control of the cash position is a vital aspect of the financial management of a concern.

There should be a balance between both cash and cash-demanding activities —operations, capital additions etc. The objectives of cash management are to make the most effective use of funds, on the one hand, and accelerate the inflow and decelerate the outflow of cash on the other.

The traditional approach to a determination of technical solvency, which stresses on the availability of current assets to discharge current liabilities, is viewed as incomplete. In this connection, James Walter has rightly observed that the appropriate topic for discussion appears rather to be whether prevailing cash inflow (plus cash resources) and the cover existing cash outflows by a sufficient margin to protect against possible reduction in inflows or increments in outflows.

A financial manager has to adhere to five ‘Rs’ of money management. These are, the right quality of money for liquidity considerations, the right quantity whether own or borrowed, the right time to preserve solvency, the right source, and the right cost of capital the organisation can afford to pay.

Significance of Cash Management

Cash management assumes more importance than other current assets because cash is the most significant and the least productive asset that the firm holds. It is significant because it is used to pay firm obligations. However, cash is unproductive and as such, the aim of cash management is to maintain adequate cash position to keep the firm sufficiently liquid to use excess cash in some profitable way.

Management of cash is also important because it is difficult to predict cash flows accurately and that there is no perfect coincidence between inflows and outflows of cash. Thus, during some periods, cash outflows exceed cash inflows, because payments for taxes dividends, excise duty, seasonal inventory buildup, etc. At other times cash inflows will be more than cash payments, because there may be large cash sales and debtors may be realised in large sums promptly.

Cash management is also important because cash constitutes the smallest portion of the total current assets, even then, considerable time of management is devoted to it.

Strategies regarding the following four factors of cash management should be evolved by the firm-

1. Cash planning- Cash inflows and outflows should be planned to project cash surplus or deficit for each period of planning. Cash budget should be prepared for this purpose.

2. Managing the cash flows- The inflow and outflow of cash should be properly managed. The inflows of cash should be accelerated, while the outflow of cash should be decelerated as far as possible.

3. Optimum cash level- The firm should decide on the appropriate level of cash balances. The cost of excess cash and the danger of cash deficiency should be matched to determine the optimum level of cash balances.

4. Investing idle cash- The idle cash or precautionary cash balances should be properly invested to earn profit. The firm should decide on the division of such cash balances between bank deposits and marketable securities.

Operational Goals of Cash Management

Precisely speaking, the primary goal of cash management in a firm is to strike trade-off between liquidity and profitability in order to maximize profit. This is possible only when the firm aims at optimizing the use of funds in the working capital pool.

This overall objective can be translated into the following operational goals:

(i) To satisfy day-to-day business requirements;

(ii) To provide for scheduled major payments;

(iii) To face unexpected cash drains;

(iv) To seize potential opportunities for profitable long-term investments;

(v) To meet requirements of bank relationships;

(vi) To build image of creditworthiness;

(vii) To earn on cash balance;

(viii) To build reservoir for net cash inflows till the availability of better uses of funds by conscious planning;

(ix) To minimize the operating costs of cash management. 

4 Facets of Cash Management 

Cash inflows and outflows do not always match. There could be either surplus or shortage. Surplus cash arises when the cash inflows are excess over cash outflows and deficit will arise when the cash inflows are less than the cash outflows. 

The balance known as synchronization firm should develop appropriate strategies for resolving the uncertainty involved in cash flow prediction and in balance between cash receipts and payments.

Firms have to come up with some cash management strategies regarding the following four facets of cash management:

1. Cash Planning:

Cash planning is required to estimate the cash surplus or deficit for each planning period. Estimation of cash surplus or deficit can be arrived at by preparation of cash planning (budget).

2. Cash Flows Management:

Cash flow means cash inflows and cash outflows. The cash flows should be properly managed, the cash inflows should be accelerated (collected as early as possible) and cash outflows should be decelerated (cash payments should be delayed without affecting firm name).

3. Determination of Optimum Cash Balance:

Optimum cash balance is that balance at which the cost of excess cash and danger of cash deficiency will match. In other words, it is the cash balance at which the total cost (total cost equals to transaction cost and opportunity cost) is minimum. Firm has to determine the optimum cash balance.

4. Investment of Surplus Cash:

Whenever there is surplus cash it should be properly invested in marketable securities, to earn profits. Firms should not invest in long-term securities, they cannot be converted into cash within a short period. 

Factor for Efficient Cash Management

Factor # (1) Prompt Billing and Mailing:

A time lag occurs from the date of despatching goods to the date of preparing invoice documents and mailing the same to the customers. If this time gap can be minimized early remittances can be expected otherwise remittances get delayed.

In the case of one organization it had been observed that the time lag was as high as one week; subsequent scrutiny revealed that the reason for delay was due to practice of preparing bills and mailing them in ‘bunches’. 

As a result the bills on earlier sales got delayed resulting in late realization once the reason for the delay was identified corrective measures were taken to prevent the bunching bottleneck of bills. This resulted in the reduction of delay in remittances. Thus accelerating the process of preparing and mailing bills held will reduce the delay in remittances and early realization of cash.

Factor # (2) Collection of Cheques and Remittances of Cash:

Delay in the receipt of cheques and depositing the same in the bank will be inevitably by taking measures for hastening the process of collection and depositing cheques/cash from customers. The following example will prove the point.


An Organization having branches in all the districts of West Bengal had been selling fertilizers to a great extent by a vast network of consignees who will get a margin for their services. Quite often the consignees were making remittances to the head office in Calcutta resulting in delays in cash realization.

An in-depth study revealed that delays can be considerably reduced by adopting the following procedure:

i. The consignees should be asked to prepare challan-cum-invoice on Credit sales which would cut-short the work of raising separate bills.

ii. Non-operating collection accounts had to be opened in the District-Level branches of the head-office bank into which cheques and cash from sales are to be deposited by the consignees under advice to the branch manager. 

The amounts so deposited are to be transferred to the main bank account of the head office telegraphically under advice to the head-office. The branch managers/their assistants should make occasional visits to the bank branches and also to the consignees for ensuring compliance with the instructions issued.

The above practice considerably reduces the delay in receipts with a resultant decrease in the incidence of interest on the cash-credit account of the head-office.

Cash Management – 10 Important Factors Affecting Cash Requirements of a Firm 

The following are the important factors affecting cash requirements of a firm:

(1) Matching of Cash Flows:

The need for maintaining cash arises when cash inflows do not take place at one time. If cash inflows match the cash outflows i.e., they take place at one time, there is no need for a cash balance. When cash outflows exceed the cash inflows, a need for cash arises so that the firm can be saved from technical insolvency. 

What is this technical insolvency? When the firm is unable to pay its short term liabilities due to shortage of cash, such a situation is called technical insolvency.

Therefore, to determine the requirements of cash, the difference between cash inflows and cash outflows should be estimated. For this purpose cash inflows and cash outflows should be forecasted. It can be done through the Cash Budget.

(2) Non-Recurring Expenditure:

In the non-recurring expenditure those expenditures are included which are incurred for the purchase of fixed assets. Fixed assets are acquired for implementing new projects or for expanding the existing production and marketing capacity or for diversification of business. 

The plan for such type of expenditure is prepared once in several years. The quantum of such expenditure is very high. Therefore, while determining the cash requirement, such expenses should also be taken into consideration.

(3) Cash Short Costs:

Cash short costs are those costs which are incurred due to shortage of cash. With the help of cash budget the timings of cash deficiency and its quantum can be forecasted.

Cash short costs include:

(i) The expenses relating to management of cash to fulfill shortage of cash, for example brokerage on sale of marketable securities.

(ii) Credit costs like interest on debentures and commitment charges.

(iii) Loss of trade discount.

(iv) Loss of goodwill costs like more bank expenses, decrease in supply of raw material, decrease in profits and sales, etc.

(4) Cost of Excessive Cash Balance:

If a firm keeps cash balance more than its requirement, it means that management loses the opportunity to invest it elsewhere. It causes loss of interest. This loss of interest income is called the cost of excessive cash balance. Therefore, firm should consider this factor too while determining the level of cash.

(5) Management Costs:

These are the cost which are meant for management of cash, For example- salary, clerical expenses, etc. These are generally of fixed nature.

(6) Uncertainty:

Sometimes, there is uncertainty in the forecasts of cash inflows. Cash inflows can be estimated correctly but there may be delay in collection from debtors. To meet these contingencies, firm must keep additional cash balance.

(7) Payment of Loans:

Firm has to repay its long term loans. Therefore, while determining cash requirements adequate cash arrangements must be made for the repayment of loans. Normally, to pay the long-term loans, new shares or debentures are issued.

(8) Firm’s Capacity to Borrow in Emergencies:

If a firm can take loans quickly at the time of its need, a low level of cash can be maintained. Firm’s ability to borrow depends on various factors. For example- relations of the firm with banks, the quantum of assets on whose security loans can be undertaken, rate of interest and demand and supply conditions for short-term loans, etc. are a few among them.

(9) The Attitude and Policy of Management:

The attitude and policy of the management towards liquidity, risk of technical insolvency, credit sales, etc. affect the level of cash. If management gives more importance to liquidity instead of profitability, the level of cash will be high. On the other hand, if management attaches more significance to profitability instead of liquidity, the level of cash will be lower.

(10) Efficiency of Management in Managing Cash:

If management follows such policies and procedures which help in easy collection of cheques from debtors and payment to creditors is delayed, the balance of cash in business can be minimised.

Cash Management – Factors Determining Cash Needs

Following are some of the factors which are to be considered for determining cash needs of a firm:

Factor # 1. Nature and Size of Business

The cash requirements of a firm mainly depends on the nature and size of a business. Trading and manufacturing concerns require more cash while service concern’s need for cash is much less. Size of business operations also affects the cash needs of a firm.

Factor # 2. Production Policies

Production policies of a firm affects the purchase of material and other components and the level of finished goods. More production for inventory means more purchases of raw material resulting into higher cash needs.

Factor # 3. Credit Policies

Policies on trade receivables like credit period allowed, cash discount offered affect the cash flow in a firm. Also, ability of a firm to get favourable credit terms from its suppliers of materials and services affects the cash needs of the firm at a particular point of time. A tight credit policy on debtors and favourable credit policies from suppliers will reduce the cash needs of a firm.

Factor # 4. Manufacturing Cycle

Cash needs of a firm also depend upon the length of manufacturing cycle of a firm. A longer manufacturing cycle will involve more investment in raw material, work-in- progress and finished goods resulting in higher cash needs. Further cash cycle will require investment in debtors before cash is reconverted again after passing through manufacturing and cash cycles.

Factor # 5. Growth and Expansion Policies

If a firm is pursing active growth and expansion strategies, then its cash needs will also increase manifold. Stability strategy will stabilize the cash needs of a firm. Hence, cash need of a firm is affected by the kind of business strategies adopted by a firm.

Factor # 6. Monetary and Fiscal Policies

Monetary and fiscal policies of the government do affect the availability of money supply in the country. These policies affect the quantum of money available from banking system to the industry. 

If banks are liberal in offering loans to the business firms, these firm will keep cash only for transaction motive. For other motives, the firms can approach the banks and can get the necessary cash at a short notice.

Factor # 7. Synchronisation of Cash Flows

If a firm has done proper planning for its cash inflows and outflows for a particular period, then it is in a position to find out cash surplus or deficit for that period. Therefore, a proper planning of cash through cash budget will help to find out the exact need of cash and it will also reduce idle cash in the system.

Factor # 8. Consideration of Short Costs

For determining an appropriate level of cash, consideration of short costs is also important. The term short costs may be defined as costs, expenses, or loss incurred as a result of deficiency of cash at a particular point of time.

Some of the costs which may be included in short costs are as follows:

(i) Loss of discounts

A firm may lose an opportunity of availing trade and cash discount due to shortage of cash.

(ii) Cost associated with restoration of required liquidity

When a firm is confronted with shortage of cash, it needs to involve in emergency borrowings at a higher rate of interest and may be required to pay penalty for not meeting its obligations on time. It may also suffer losses in liquidating its marketable securities. These will result in huge costs to the firm.

(iii) Costs of defending legal suit

When a firm fails to meet its obligations on time, it may face a legal action from creditors. Firm has to incur costs in defending the legal action besides arresting fall in its reputation.

Cash Management – Motives for Holding Cash: Transaction, Precautionary, Speculative and Compensation Motive

Although cash does not generate any profit itself, yet certain firms maintain some amount of cash balance. It is because of the fact that is maintained for making several types of payments. There are four main motives of holding cash. 

These are: 

(1) Transaction Motive 

(2) Precautionary Motive

(3) Speculative Motive 

(4) Compensation Motive 

(1) Transaction Motive: 

One of the important reasons for maintaining cash is to facilitate business transactions. Business needs cash for various payments in ordinary course of its operation. It includes payment for purchase of material, and payment of wages, salary, interest, dividend, taxes and other expenses. 

Similarly, business gets cash from its selling activities and other external investments. But there is no coordination between the inflow and outflow of cash. Sometimes, inflows of cash are more than the outflows and sometimes outflows of cash are more than its inflows. 

When the expected cash receipt is short of the required payment, cash is needed by the firm so that liabilities could be paid. If cash receipts match with the cash payments, business does not need cash for the transactional purposes. 

(2) Precautionary Motive: 

Firm needs cash to combat some contingencies. 

Some of the contingencies for which additional cash is required include: 

(i) Strikes, floods, failure of important customers. 

(ii) Slow rate of cash collection from debtors. 

(iii) Rejection of orders by customers due to their dissatisfaction. 

(iv) Rise in cost of raw materials, etc. 

(3) Speculative Motive: 

It means to make use of profitable opportunities by firm. Sometimes, the firm wants to make use of such profitable opportunities which are outside the operation of the business. For this purpose, firm retains some cash. 

Some of these opportunities are: 

(i) Opportunity to purchase raw material at low price by payment of cash immediately. 

(ii) Opportunity to purchase securities at falling prices. 

(iii) Purchasing raw material at a time when its prices are the lowest. 

(4) Compensation Motive: 

One more objective to maintain cash is to compensate for providing free services by banks to the business. Banks provide a number of services to its customers, like clearance by cheques, credit information about other customers, transfer of funds, etc. 

For certain services banks charge commission but some of the services are provided by them free of cost for which they require indirect compensation. 

For this purpose they wish their customers to maintain minimum cash balance. This bank balance cannot be used by the firm for its business transactions but the bank can use it to earn profit and thus compensates itself for the cost of services to the customers.

Functions of Cash Management 

Cash planning, managing the cash flows, determining optimum cash level and proper utilisation of surplus cash are the important areas/functions of cash management. Let us discuss each in detail.

Function # 1. Cash Planning:

Planning is the first activity for any area of management. Hence, for efficient cash management, a proper cash planning is required as a first step. Cash planning refers to a precise determination of position of all cash inflows and outflows during the planning period and a proper synchronization of all such cash inflows and outflows.

Through cash planning, a statement of all receipts (cash inflows) and payments (outflows) at different points of time during the budgeted period is prepared. It helps the management to find out the deficit or surplus of cash at different points of time. The statement so prepared is known as cash budget.

Function # 2. Cash Budget:

Cash budget is the most important tool to plan and control cash inflows and outflows. A cash budget may be defined as a statement consisting the summary of the firm’s estimated cash inflows and outflows for the budget period. It is a summary statement of future estimated receipts and payments over a defined period of time.

It gives us detailed information regarding timings and quantity of expected cash inflows and outflows for the future period. Cash budget can be prepared on weekly, monthly, quarterly, half yearly or yearly basis. Cash budgets for a longer period can be prepared if longer period cash forecast are made with reasonable certainty.

Cash forecasts are needed to prepare a cash budget. It is the technique of estimating cash receipts and payments for a future period. By preparing a cash budget, finance manager can fairly estimate the cash needs of the firm at different point of time of a budget period.

He can plan for the expected shortage of cash and can also invest the surplus cash profitably. Through cash budget, he can exercise control over cash and maintain the required liquidity for the firm.

A cash budget is usually prepared by writing opening cash balance as the starting point. All receipts for the periods are added to the opening balance to find the total cash available during the period. The receipts may consist of both revenue and capital nature. These may belong to any period whether future, current or past.

In nutshell, all receipts whether of capital or revenue nature or belonging to any period has to be taken into account. From the total cash available, all payments for the period whether of capital or revenue nature or belonging to any period are deducted to find the closing cash balance.

Function # 3. Managing Cash Flows /Floats:

Cash flow management is the management of collection and disbursement of cash.

The cash flows are managed with following objectives in mind:

1. Collection of cash inflows from customers as quickly as possible so that funds are available to the firm as soon as possible.

2. Payment to creditors and other parties as slowly as possible so that funds remain available to the firm as long as possible.

Managing Cash Inflows:

The first objective of efficient cash flow management is to speed up the process of cash inflows. This can be done to collect the cash from customers as early as possible. Customers should be billed promptly and should be encouraged to pay within the period of payment allowed to them. Possibility of offering them cash discounts can also be considered for those who wants to make early payment.

Managing Cash Outflows:

The second objective of efficient cash flow management is to slow down the disbursements of accounts payable so that the funds remain available to the firm as long as possible. Firstly, firms should avoid early payment in all cases. Also, firms should use credit terms to the fullest extent possible.

The firm should pay its obligations on the due dates. Secondly, the firm should adopt a system of centralised controlled disbursement. All payment should be made through a centralised payment account. This will also help the firm to slow down its disbursement and in the process conserve cash for the firm.

Centralised disbursement system will increase the transit time for the cheques. This will result in delay in presentation of cheques for encashment by the parties which are located away from the centralised disbursement system.

Delaying payments results in more availability of funds at a particular point of time. However, the firm should not delay in making payments at the cost of its goodwill. When the firm fails to meet its obligation on time, it may face difficulty in obtaining the required trade credit. Finally, the objective should be to keep cash available in the right amount and at the right time to meet the financial obligations at the minimum cost.

Function # 4. Collection Float Management:

A firm receives most of its payments in the form of cheques. Once a cheque is received, the process of its encashment starts. Money in the form of cheques is called a deposit float or collection float. Attempts should be made to reduce this float.

The deposit float is caused by:

(i) Postal float

It is due to postal delays i.e. time taken by the cheque to reach through post.

(ii) Processing float

It is due to accounting time, i.e. the time taken by the firm to do necessary entries in the books of accounts.

(iii) Processing float

It is because of the time taken by the banking system to clear the cheque and credit the firm’s account.

In India, usually, a relatively longer time is taken in converting these floats into actual funds. A larger firm can adopt cash management techniques like concentration banking and lock-box system to speedily convert deposit float into cash.

Function # 5. Concentration Banking:

A large firm having business interest over a larger geographical area i.e. in different cities or towns across a country like India, can adopt concentration banking procedure to minimise time starting from collection of cheques to the availability of funds. Concentration banking, first adopted in the U.S.A, is a system of decentralising collections of accounts receivable.

Under this system, a large number of collection centres are established by the firm in different cities or towns. The collection centres will be required to collect cheques from the customers in their areas and deposit them in the local bank account opened for the purpose.

In this way local banks will receive the funds against these local cheques immediately. The local bank will send the funds telegraphically on a daily basis over a stipulated minimum balance to a concentration bank account usually opened at the head office of the company.

Hence, this procedure will help speedy collection of cheques and their encashment from large geographical area and immediate transfer of such funds to the company. This will be done through reducing mailing, processing time and encashment time by banks.

Function # 6. Lock-Box System:

This is another system of speeding up collection of cheques and their encashment. Under this system a firm hires a post-office lock-box at important collection centres established by it. Customers in their respective centre’s area are instructed to mail their cheques to these boxes.

The firm’s local bank are instructed to collect these cheques from these boxes daily or many times a day depending upon the volume of transactions and deposit the cheques in firm’s local bank account. Standing instructions are given to the local banks to send the funds over a fixed balance immediately to the head office account.

This system not only reduces the mailing time but also helps in reducing the processing time usually taken for depositing these cheques. The lock-box system has a cost. A cost-benefit analysis can be done before taking a decision to adopt the system.

Function # 7. Disbursement Float Management:

Efficient management of float is an important step in slowing disbursement. The term disbursement float refers to the amount of money tied up in the cheques that have been written, but have not yet been collected, presented or encashed.

This may arise because of following stages a cheque goes through:

(i) Billing float

Time elapsed between the sale transaction and mailing of the bill or invoice is called billing float. As a result payment is delayed for some days.

(ii) Mailing float

Once a cheque has been prepared, it is sent to the creditor by post. Time taken by postal authorities to deliver the cheque to its addressee is known as mailing float. Centralised disbursement system will increase this float and hence more availability of funds in firm’s account.

(iii) Cheque processing float

This is the time taken by the supplier firm to process and pass necessary journal entries in their account before cheque is deposited in the bank account for encashment.

(iv) Bank processing float

This refers to the time taken by the bank for its clearing and encashment through the banking system.

Managing Floats under Modern Banking System:

Money in the form of a cheque, starting from its writing stage to its ultimate realization and credit in a firm’s account represents idle funds in the banking system. This is due to the fact that when a firm writes a cheque, it is required to maintain sufficient balance in its account. The funds cannot be used by any of the firms during the banking processing time.

The focus of the banking sector reforms have been to speed up the process of transfer of funds i.e. both liquid funds in the form of cash and float funds in the form of cheques. These were intended to improve the availability of more funds to the business firms and to reduce the idle funds tied up in the banking system.

With the advent of Core Banking System in Commercial Banks, RBI launched services of faster tools of remittances like RTGS / NEFT / CTS etc. to develop alternate delivery channel and minimize the processing time for clearance of the financial instruments like cheques etc., which in fact has resulted in making the concept of Float Funds as a concept of past.

RBI’s initiatives were launched in a systematic manner and the major components of system for faster remittances are as under:

(a) Development of Indian Financial System Codes (IFSC);

(b) Development of Structured Financial Messaging System (SFMS);

(c) Putting in place the –

(i) Application Platform for launching ECS, RTGS & NEFT etc.

(ii) Cheque Truncation System (CTS); and

(iii) Necessary statutory modifications to incorporate changes in banking system.

(a) The mother of all Changes is the Introduction of IFSC Code for the Banks:

IFSC stands for Indian Financial System Code. The code consists of 11 Characters – First 4 characters represent the entity; Fifth position has been defaulted with a ‘0’ (Zero) for future use; and the Last 6 character denotes the branch identity.

The banks devise branch wise codes to be placed in last 6 character slot. IFSC is being identified by the RBI as the code to be used for various payment system projects within the country, and it covers all networked branches in the country.

(b) Structured Financial Messaging System (SFMS):

Structured Financial Messaging System (SFMS) is a secure messaging standard developed to serve as a platform for intra-bank and inter-bank applications. It is an Indian standard similar to SWIFT (Society for World-wide Interbank Financial Telecommunications) which is the international messaging system used for financial messaging globally.

In the Structured Financial Messaging System (SFMS), IFSC is being used as the addressing code in user- to-user message transmission. SFMS can be used practically for all purposes of secure communication within the bank and between banks.

RBI applications like Real Time Gross Settlement (RTGS), Negotiated Dealing System (NDS), Security Settlement System (SSS) and Integrated Accounting System (IAS) have interface with SFMS. The intra-bank part of SFMS, which is most important, is used by the banks to take full advantage of the secure messaging facility it provides.

The inter-bank messaging part is useful for applications like Electronic Funds Transfer (EFT), Real Time Gross settlement System (RTGS), Delivery Versus Payments (DVP), Centralized Funds Management System (CFMS) etc. Now, the SFMS is also being utilized by the Banks for advising Inland Letters of Credit as well as Domestic Bank Guarantees, to replace the Hard Copy of the Document for minimizing the process time involved in the transaction.

(c) The Applications Platform Developed by RBI:

(i) The acronym RTGS stands for Real Time Gross Settlement. RTGS system is a funds transfer mechanism where transfer of money takes place from one bank to another on a real time and on gross settlement basis. This is the fastest possible money transfer system through the banking channel. RTGS uses SFMS for messaging.

Settlement in real time means payment transaction is not subjected to any waiting period. The transactions are settled as soon as they are processed. Gross settlement means the transaction is settled on one to one basis without bunching with any other transaction. Considering that money transfer takes place in the books of the Reserve Bank of India, the payment is taken as final and irrevocable.

Under normal circumstances the beneficiary branches are expected to receive the funds in real time as soon as funds are transferred by the remitting bank. The beneficiary bank has to credit the beneficiary’s account within two hours of receiving the funds transfer message.

(ii) Electronic funds Transfer System (EFT) or National Electronics Funds Transfer (NEFT) System facilitates transfer of funds electronically from any bank branch to any other bank branch in the country. For being part of the NEFT funds transfer network, a bank branch has to be NEFT- enabled.

Individuals, firms or Corporates maintaining accounts with a bank branch can transfer funds using NEFT. Even such individuals, firms or Corporates who do not have a bank account (walk in customers) can also deposit cash at the branch with instructions to transfer funds using NEFT. A separate Transaction Code (No. 50) has been allotted in the NEFT system to facilitate walk-in customers to deposit cash and transfer funds to a beneficiary.

(iii) The CTS stands for CHEQUE TRUNCATION SYSTEM. It eliminates the need to move the physical instruments (i.e., cheques/DDs etc.) across branches and substitutes the traditional clearing system with the Image-based Clearing System (ICS).

ICS is basically an online image- based cheque clearing system where cheque images and Magnetic Ink Character Recognition (MICR) data are captured at the collecting bank branch and transmitted electronically, thus speeding up the process of collection or realization of cheques and the cheques may effectively be cleared in T+1 i.e. the next day.

(iv) Along with the launch of IFSC code, the SFMS regime and CTS clearing system, the Government have passed various amendments in Negotiable Instrument Act, Banking Regulation Act and IT Act etc. to recognize and legalize the transactions underlying the RTGS / NEFT / CTS clearing systems.

Because of the introduction of a system of faster transfer of funds, overall availability of funds to the business has increased. This has also drastically reduced the float funds in the banking system. Now the firm should use these modern means to manage its cash flows/floats efficiently.

Function # 8. Optimum Cash Balance:

The liquidity position of a firm will suffer if it keeps a lower cash balance. In order to increase the liquidity position it has to sell some marketable securities incurring loss of interest and transaction costs. However, profitability may be higher because of maximum utilisation of funds.

On the other hand, if the firm keeps higher cash balance, its liquidity will improve but profitability will decrease because of loss of interest on idle funds. Thus, more liquidity involves an opportunity cost. For a finance manager, who is managing the cash, it is necessary to know the optimum level of cash and the investment in marketable securities.

Optimum cash balance can be determined after taking into account the relevant cost involved in cash management i.e. transaction cost, opportunity cost etc. A number of cash management models have recently been developed to determine optimum level of cash balance.

2 Critical Functions of Cash Management – Cash Budget and Minimum Cash Balance

Cash Management usually involves two critical functions:

(i) Monitoring cash situation i.e., forecasting the receipt and payment of cash and

(ii) Managing the cash balance i.e., investing the cash when a surplus is there or raising the cash quickly when it is urgently needed.

Let us look at these two functions.

1. Cash Budget:

Cash Budget involves both forecasting and cash planning on a short term basis. A cash budget is prepared by a firm to estimate the inflow and outflow of cash, usually on a monthly basis, for the coming months. The objective is to know what are the sources from which cash is expected and what are the items on which cash needs to be paid in the coming few months? Although there is no fixed period for which cash budget is prepared but it does not, normally, exceed one year.

By looking at the estimates of cash inflows and outflows we know that in which month we earn a surplus and in which month there is a deficit. This helps us manage both the surplus and deficit. If we are expected to earn a surplus which is not expected to be needed in the coming months, we may plan for its short term investment and if a deficit is expected, we may plan for arranging the cash for this deficit period. The whole purpose is that we are not caught unaware in any given situation and are ready for any eventuality.

For preparing a cash budget, we first identify the sources of cash receipts. They are usually from cash sales, collection from receivables, receipt of cash by way of interest or dividend, refund of short term advances by debtors or from monies raised from different long term sources of funds like term loans, bonds, equity or preference shares, sale of assets and short term sources like bank overdrafts, cash credits, bills discounting etc.

The payment of cash is usually on account of cash payment for raw material, labour, power/ fuel, general maintenance, office expenses and salaries, interest, dividend, taxes, payment of loan installments etc. Here we do not make any distinction whether it is a revenue or a capital item of receipt or payment. After identifying all the items of cash receipts and cash payments, a cash budget is prepared, usually, on a monthly basis.

The following illustration will explain how a cash budget is prepared.


ABC Stores is a departmental store which is a retail house selling a variety of goods to customers in Lucknow.

The following information is available about its financial transactions:

(i) Its sales figures are as follows –

May and June Rs. 90,000 per month

July and August Rs. 1, 00,000 per month.

September and October Rs. 1, 20,000 per month.

November and December Rs. 1, 30,000 per month.

(ii) The sales are 50% on cash and 50% credit. 50% of receivables are collected in one month while 50% are collected in two months.

(iii) The purchase of goods is as follows –

June and July – Rs. 60,000 per month.

August, September and October – Rs. 80,000 per month.

November and December – Rs. 1, 00,000 per month.

(iv) The purchases are on one month credit.

(v) The salary payments are Rs. 25,000 per month.

(vi) Other expenses are Rs. 15,000 per month.

(vii) The Store is required to make a payment of Rs. 5,000 as municipal taxes in October.

(viii) The Store is to receive a dividend of Rs. 18,000 from its investments in October.

(ix) The repair of certain equipment is likely to cost Rs. 5,000 in December.

(x) The store is likely to have a cash balance of Rs. 5000 as on July 1, 2014.

Prepare a cash budget of ABC Store for a period of 6 months from July 2014 to December 2014 and show the surplus or deficit in each month. Calculate cash balance as on December 31, 2014.


Before making the cash budget we need to calculate cash sales and collections for each month. Cash sales are 50 % of given sales figures.

Collections will be calculated as follows:

July – 50% of credit sales for May and 50% of credit sales of June

August – 50% of credit sales of June and 50% of credit sales for July and so on.

Similarly payments for goods purchased will be in the next month of the purchase. All other receipts and payments are to be shown in the given month. Now, we make the given cash budget. 

Thus, we find that the cash budget is helpful to us in finding the whole pattern of cash receipts and cash payments for each month of the given six months. It also shows the surplus or deficit of cash receipts or payments for each month and finally, it presents a summary statement which tells us the opening and closing balance of cash for each month. We get the closing balance of Rs. 6,500 at the end of December 2013.

In the above example, we find that there is surplus in some months and deficit in some. However, the deficit is met by the opening balance for the given months. Thus, there is no problem of meeting our liabilities for any month. This may not always be the case. In real life, there may sometimes be a liability which can neither be met out of the receipts nor by the opening balance for the month. The cash budget is helpful in such situations also.

If such an eventuality is likely to arrive, we have enough prior notice to arrange for the funds. Such funds may be arranged by a short term advance from a bank or through the sale of some marketable securities or by postponing some payments with the consent of the creditors.

Cash budget helps us by forewarning about such an eventuality and gives us time to do the needful. In the absence of a cash budget we would be caught unawares and the failure to meet the liability will seriously jeopardize the credibility and reputation of a firm.

In the following example such a situation has been presented:


Delhi Plastics is a manufacturer of plastic goods.

Its estimates of revenue and expenditure for the six months starting October 2013 are as follows:

(i) Sale of products are as follows –

November and December Rs. 80,000 thousand per month

January and February Rs. 1, 00,000 per month

March and April Rs. 1, 20,000 per month

(ii) Sales are 60% on cash and 40% on credit. Half the credit sales are collected within one month and half in two months.

(iii) Raw Material purchase is Rs. 50,000 per month for the first 3 months and Rs. 65,000 in the next 3 months. Raw material suppliers provide a credit line of one month.

(iv) Labour expenses are Rs. 30,000 per month which is to be paid in the same month.

(v) Power expenses and other sundry expenses are Rs. 15,000 per month.

(vi) The Company is likely to have a tax liability of Rs. 15,000 in March.

(vii) The Company is expected to receive Rs. 5,000 as refund of loan in February and Rs. 15,000 as dividend in April.

(viii) The Company is expected to have an opening balance of Rs. 15,000 as on January 1, 2014.

Prepare a cash budget for four months starting from January 2014. Find the surplus or deficit for each month and find the cash balance on the closing date of April. 

In the given example, we find that the company has a deficit in its receipts and payments but they can be met out of the initial cash balance for two months i.e. January and February. However, it is not sufficient to meet the deficit of March which is Rs. 13,000. We need to borrow Rs. 10,000 only for one month to meet this liability.

There is enough surplus in April to pay out this short term loan. Accordingly, we show a loan of Rs. 10,000 in March and its refund in April. If we do not show the raising of the loan and its refund then the closing balance for March will be – 10,000 which is illogical because the cash balance cannot be negative.

2. Minimum Cash Balance:

In the above illustration, we see that the closing cash balance in March is zero. This is again not a satisfactory situation. Companies would always like to keep some minimum cash balance to meet any unforeseen expenditure. 

Suppose, the company has a policy to keep minimum cash balance of Rs. 5,000, it would, then, have to borrow Rs. 2,000 in February and Rs. 13,000 in March to have a minimum balance of Rs. 5,000 both in February and March. The whole of this can be paid back in April and the closing balance in April would still be the same i.e. Rs. 11,000.

The summary, then, would appear as follows: 

Just as we borrow when there is a shortage of funds, we also have to take into account that there may be situations when we have good cash balance which is not required in the short run. In such a situation, it is not prudent to let that cash remain idle with us. There are always some short term investments opportunities which will earn us interest and maintain liquidity at the same time.

Such short term investment opportunities are – fixed deposits in commercial banks, purchase of commercial papers, investment in treasury bills and other money market instruments. Thus, cash budget is very useful in forecasting the situations of both a surplus and a deficit of cash receipts and the consequent cash position. This surely helps us either to arrange for cash whenever there is a shortage or to invest the cash fruitfully whenever there is unused money.

Cash Management Models – Inventory type Model and Stochastic Models

In recent years, several types of mathematical models have been developed that help to determine the optimum cash balance to be carried by a business organisation. The purpose of all these models is to ensure that cash does not remain idle unnecessarily and at the same time the firm is not confronted with a situation of cash shortage.

All these models can be put in two categories:

1. Inventory type models or William J. Baumol’s Cash Management Model

2. Stochastic models or Miller and Orr Model.

Model # 1. William J. Baumol’s Cash Management Model:

Inventory type models have been constructed to aid the finance manager to determine optimum cash balance of his firm. William J. Baumol’s Economic Order Quantity (EOQ) model applies equally to cash management problems under conditions of certainty or where the Cash Flows are predictable. However, in a situation where the EOQ Model is not applicable, stochastic model of cash management developed by Miller and Orr helps in determining the optimum level of cash balance.

Inventory Type Models or William J. Baumol’s Cash Management Model or Baumol’s EOQ Cash Management Model (1952):

This model was developed by William J. Baumol. In November 1952, he published this model in Quarterly Journal of Economics, titled ‘The Transactions Demand for Cash – An Inventory Theoretical Approach’. This was the first formal model of cash management that incorporated opportunity cost and transaction costs.

According to this model, optimum cash level is that level of cash where the carrying costs and transactions costs are the minimum. The carrying costs refer to the cost of holding cash, namely, the interest foregone on marketable securities.

The transaction costs refer to the cost involved in getting the marketable securities converted into cash. This happens when the firm falls short of cash and needs to sell the securities resulting in clerical, brokerage, registration and other costs.

The optimum cash balance according to this model will be that point where these two costs are minimum. The Baumol’s model finds a correct balance by combining holding cost and transaction costs, so as to minimise the total cost of holding cash (Figure 6.4) – 

(a) Assumptions:

The following are the assumptions of Baumol’s model:

1. The first assumption of this model is that the firm is able to forecast correctly and precise­ly the amount of cash required by it. Cash needs of the firms are known with certainty.

2. The firm makes its cash payments uniformly over a period of time. Thus, the cash payments arise uniformly over the future time period.

3. The firm very well understands the opportunity cost of the cash held by it. The opportunity cost of interest forgone by not investing in marketable securities. Such holding cost per annum is assumed to be constant.

4. The transaction cost of the firm is constant and known. The transaction cost is the cost incurred whenever the firm converts its short-term securities to cash.

5. The surplus cash is invested into marketable securities and those securities are again disposed of to convert them again into cash. Such purchase and sale transactions involve certain costs such as – clerical brokerage registration and other costs. The cost to be incurred for each such transaction is assumed to be constant/fixed. In practice, it would be difficult to calculate the exact transaction cost.

6. The short-term marketable securities can be freely bought and sold. Existence of free market for marketable securities is a perquisite of the Baumol model.

(b) Limitations:

The limitations in Baumol’s model are as follows:

1. The model can be applied only when the payments position can be reasonably assessed.

2. The major demerit of this model is that it does not allow the Cash Flows to fluctuate. The Cash Flows are assumed to be constant and known over the time period, which practically is not possible in real world. Firms are unable to use their cash balance uniformly.

3. Similarly the firms cannot predict their daily Cash Inflows and outflows.

4. Degree of uncertainty is high is predicting the Cash Flow transactions. Behaviour of Cash Inflow and outflow is assumed to be too smooth and certain. Cash Inflow and outflow of businesses are too erratic. Daily cash balance may fluctuate, leading to an unpredictable pattern of Cash Flow. Thus at no point an ideal optimum cash balance C be maintained practically.

5. The model merely suggests only the optimal balance under a set of assumptions. But in actual situation it may not hold good. Nevertheless it does offer a conceptual framework and can be used with caution as a benchmark.

Model # 2. Stochastic Models or Miller-Orr Cash Management Model (1966):

The Miller and Orr Model (MO) model overcomes the demerits of the Baumol model. This model assumes that the Net Cash Flows are normally distributed with a zero value of mean and Standard Deviation.

In other words, the MO model extended the existing Baumol model and stated that cash balances take too erratic a pattern of distribution over a time period. However, over long periods, they tend to show normal distribution.

(a) The MO model basically states that there are two control limits:

1. The upper control limit

This states the upper limit for cash balance. If at any time the cash balance exceeds this limit, the extra cash is transferred to marketable securities and investments.

2. The lower control limit along with the return point

This states the lower limit for cash balance. If at any time the cash balance reach this limit, the investments are liquidated and liquidity of the firm is enhanced.

Thus, when the Cash Flows of the firm deviate randomly, they hit the upper limit. At this point, the firm purchases adequate amount of marketable securities, which helps the firm to reduce its free cash and thus return to a normal level of cash balance (return point).

In the same way, when the firm’s Cash Flows deviate lower and hit the lower limit, the firm liquidates its investments (marketable securities) so that its cash balance returns to the normal level (return point).

(b) Assumptions:

The basic assumptions of the model are as follows:

1. The major assumption with this model is that there is no underlying trend in cash balance over time.

2. The optimal values of ‘h’ (upper limit) and ‘z’ (return point) depend not only on oppor­tunity costs, but also on the degree of fluctuation in cash balances.

(c) Limitations:

The model is having the following limitations:

1. The first and important problem is in respect of collection of accurate data about transfer costs, holding costs, number of transfers and expected average cash balance.

2. The model does not take into account the cost of time devoted by financial managers in dealing with the transfers of cash to securities and vice versa.

3. The model does not take into account the short-term borrowings as an alternative to selling of marketable securities when cash balance reaches lower limit.

This model is designed to determine the time and size of transfers between an investment account and cash account. In this model, control limits are set for cash balances. These limits may consist of h as upper limit, ‘z’ as the return point and ‘0’ (zero) as the lower limit (Figure 6.5) –

When the cash balance reaches the upper limit (h), the transfer of cash equal to h-z is invested in marketable securities account. Then the new cash balance is z. When cash balance touches lower control limit (0), marketable securities to the extent of Rs. (z- 0) will be sold. Then the new cash balance again return to point z.

During the period when cash balance stays between (h, z) and (z, 0), i.e., high and low limits, no transactions between cash and marketable securities account is made.

(d) The spread between the upper and lower cash balance limits can be computed using Miller and Orr Model as follows: 

With the control limits the Miller-Orr model will minimise the total costs—fixed and oppor­tunity—of cash management. The average cash balance is approximately (z + h)/3. However, for obvious reasons, this balance will be higher than that under the inventory model.

The MO Model is more realistic since it allows variations in cash balance within the lower and upper limits. The finance manager can set the limits according to the firm’s liquidity requirements, i.e., maintaining the minimum and maximum cash balance

Cash Management – Determining the Optimum Cash Balance under Certainty and Uncertainty

1 Optimum cash balance under certainty: 

(A) Baumol’s Model

This model considers cash management similar to an inventory management problem.

Assumptions of Baumol’s model

1. The firm is able to forecast it cash need with certainty

2. The firm cash payments occur uniformly over a period of time

3. The opportunity cost of holding cash is known and it does not change over a period of time

4. The firm will incur the same transaction cost whenever it converts its securities to cash.

Let’s 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 at this point sells enough marketable securities so that cash balance becomes C again. This process keeps repeating over time. The average cash balance at any point in time will be C/2.

This can be graphically represented as: 

Where C* is the optimum cash balance, b is the conversion 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 the increase in conversion cost “b” and total funds required and decrease with the opportunity cost.

Limitations of Baumol’s model

The biggest limitation of the Baumol model is that it assumes that the cash flows are certain and known in advance. It does not allow the cash flows to fluctuate. Also, it assumes uniform spending of cash. Firms in practice do not use their cash balance uniformly nor are they able to predict daily cash inflows and outflows.

2. Optimum Cash Balance under uncertainty:

(B) The Miller-Orr Model

The Miller-Orr Model overcomes the shortcomings present in the Baumol’s model. It assumes that net cash flows are not certain and not known in advance. In fact, cash flows follow normal distribution with a zero mean & standard deviation.

The MO model talks about a ceiling and a floor within which cash flows are assumed to fluctuate. They are called control limits. These two control limits are known as upper control limit & the lower control limit. There is a return point as well.

What happens if the firm’s cash flow reaches the upper limit? Here, firm buys sufficient marketable securities so that its cash balance reduces and comes down to return point. Similarly, when the firm’s cash flows go down and reach the lower limit, it sells marketable securities to the extent that its cash balance goes up to return point.

Graphically the Miller Orr model can be depicted as follows: 

The assumptions of this model are more realistic. It allows for random fluctuations in cash balances within a preset limit. The manager can find out the variance of daily cash balances from the past data of the firm.

Cash Management – Cash Budget: Meaning, Parts and Utility

Meaning of Cash Budget: 

A cash budget is an estimate of cash receipts and cash payments for a future period of time. It is prepared to forecast the cash requirements for a given period and indicates the surplus or shortage of cash during the budget period. 

There are two parts of cash budget: 

a. Cash Receipts – Cash is mainly received from cash sales, collection from debtors, income from investments etc. 

b. Cash Payments – Cash is mainly paid for cash purchases, payment to creditors, payment for expenses etc. 

By estimating the cash receipts and cash payments for a future period it can be estimated that in which months there will be surplus cash and in which months there will be deficiency of cash resources. 

Utility of Cash Budget:

(i) Helpful in Estimating the Future Cash Requirements: 

A cash budget estimates the excess or shortage of cash at the end of each month. As such, it enables the management to make a suitable plan to arrange the cash at the required time. 

(ii) Helpful in the Selection of Proper Source of Finance: 

Cash budget indicates whether the shortage of cash is for short-term or for long-term. This information helps in the selection of proper source of finance. If there is short-term shortage of cash, bank overdraft may be a proper source of finance. But if the shortage is for long-term, company may plan to accept public deposits or issue debentures or new shares. 

(iii) Helpful in the Investment of Surplus Cash: 

Cash budget indicates the amount of surplus or idle cash at the end of each month. As such the management can plan to invest the idle cash in short-term securities which on the one hand will yield some income and on the other hand can be sold in case of need. 

(iv) Helpful in Getting Cash Discount: 

It shows the availability of surplus cash at the end of each month. Thus the management can plan to take advantage of cash discounts by purchasing the goods for cash during periods when surplus cash is available. 

(v) Helpful in Planning for Purchase of Assets: 

Cash budget also enables the management to ascertain whether sufficient cash will be available to provide for the purchase of an asset internally. In case cash budget does not disclose enough surplus of cash, the management will have to raise cash from external sources to finance the purchase of asset. 

(vi) Helpful in the Determination of Proper Dividend Policy: 

In order to declare dividend on shares, only the adequacy of profits is not enough but the availability of sufficient cash is also necessary. Sometimes a firm may have adequate profits, but even then it may face shortage of cash. This may happen due to excessive credit sales or due to purchase of some fixed asset. In such cases the company can restrict its cash dividends till the availability of adequate cash. 

(vii) Restricts Overspending: 

Cash budget restricts the tendency of management to overspend. Since the management knows the available cash resources well in advance, expenditure can be controlled and payments can be adjusted to match the resources. 

(viii) Effective Control on Cash: 

After the end of the budget period, the actual cash receipts and payments are compared with the figures of cash budget, the reasons for variations are investigated and suitable remedial action is taken by the management.

Cash Management – Cash Planning

Cash planning and control of cash are the central point of finance functions. Maintenance of adequate cash is one of the prime responsibilities of the finance manager. Cash budget helps maintain adequate cash always.

Cash control also includes cash planning. Since planning and control are the twins of management. Cash planning is a technique to plan and control the use of cash. A projected cash flow statement is prepared based on expected cash receipts and payments, anticipation of the financial condition of the firm. Cash planning may be prepared on a daily, weekly, monthly or quarterly basis.

The period for which the cash planning is prepared depends on the size of the firm and managements’ philosophy. Large firms, prepare daily and weekly forecasts. Medium-sized firms prepare weekly and monthly forecasts. 

Small firms may not prepare cash forecasts due to non-availability of data and less scale of operations. But in a short period they may survive but over a long period they have to prepare cash planning for success of the firm. 

Main Devices of Cash Management – Cash Budget, Cash Flows Statement, Cash Flows Ratios and Cash Management Model

Devices of Cash Management:

Among the important aspects of cash management, control of the level of cash and control of cash inflows and cash outflows is included.

The following are the main devices of cash management:

(1) Cash Budget

(2) Cash Flows Statement

(3) Cash Flows Ratios

(4) Cash Management Model

(1) Cash Budget:

Cash Budget is an important technique of planning and controlling cash receipts and payments. Firms should maintain an adequate cash balance and must avoid excessive or inadequate cash in the firm. Therefore, the firm must determine its cash requirements.

Cash budget helps the firm to determine its cash requirements so that finance can be arranged in time. Cash budget is a statement which presents cash inflows and cash outflows for a future period of time. It also provides information about the quantum of receipts and payments in future and the timings of such receipts and payments.

Usefulness of Cash Budget:

(i) It helps in determination of necessary cash requirements for the operation of business.

(ii) It provides information about the quantum and timings of cash receipts and payments on future dates.

(iii) It helps the management to ascertain when the firm will need additional cash and when it will have surplus cash.

(iv) At the times of deficiency of cash in the firm, it helps to manage finance in time.

(v) According to the information available, in the cash budget, necessary changes can be made in policies of the firm relating to receivables and inventory.

(vi) Firms can take advantage of cash discounts.

(vii) It can plan investment of surplus cash in time.

(viii) Future plans can be made regarding the repayment of short-term and long-term loans.

(ix) To face the uncertainty of cash inflows, management can determine safety level with the help of cash budget.

(2) Cash Flow Statement:

Cash flow statements present the changes in cash position between two dates. If a business has a cash balance of Rs.10,000 on 31st Dec. 2013 but has a cash balance of Rs.20,000 in the balance sheet of 31st Dec. 2014, it would mean that during 2014, there has been additional cash inflow of Rs.10,000. Cash flow statement explains the reasons for this cash inflow or cash outflow.

This statement helps the management in preparation of an immediate future plan. With its help, such causes can be ascertained which explain why the liquidity position is weak despite adequate profits. A firm may have inadequate cash despite increasing profits. This statement highlights the financial policies adopted by business.

(3) Cash Flow Ratios:

For the purposes of cash planning and controlling, various ratios can be used.

Some important among them are:

(a) Cash Turnover:

This ratio is a measure of the speed of cash and efficiency of management of cash.

Cash Turnover = Sales per period / Initial Cash Balance

High cash turnover is an indicator of high efficiency of cash management. High turnover ratio means that for a given level of sales the requirement of cash will be less. High turnover ratio shows less liquidity but high profitability. For seasonal industries, different turnover ratios will have to be calculated for different seasons.

(b) Cash Flow Coverage:

If the firm has managed cash from loaned capital, it will have to pay principal and interest as per the terms of loan. Firm’s ability to pay the principal and interest is an indicator of its credit worthiness, which depends on availability of cash. Cash flow coverage ratio is a measure of this ability.

Cash How Coverage = Annual cash flow before interest and taxes / Interest + Principal Payments (1/1-0)

Where t is the tax rate and Cash flows mean earnings before interest and taxes plus deprecation.

Higher the cash flow coverage, more will be the credit worthiness of the firm and its financial risk will be lower. The ratio of one year can be compared with that of past years. 


The following data relate to two years’ working of a firm: 

Because cash flow coverage ratio of the second year is higher, therefore, credit worthiness of firm is higher in the second year as compared to first year and it has lesser financial risk in the second year.

(c) Cash to Average Daily Purchase Ratio:

This ratio shows the liquidity, credit worthiness and ability to take additional credit. This ratio also helps to determine cash balance needed to meet daily requirements of cash. This ratio is complementary to current ratio and liquidity ratio. 

(4) Cash Management Model:

To determine optimum cash balance, cash management models can be used. One of such models is called Inventory Decision Model. The model used to determine Economic Order Quantity (EOQ) in Inventory Management can be used for Cash Management also. Under this model, optimum level of cash means the level of cash at which the minimise costs of cash balance and its transaction costs are minimum.

Thus, EOQ model helps to minimise both types of these costs. In other words, this model establishes balance between carrying costs of cash and its transaction costs.

The carrying cost of cash balance means the rate of interest which could be earned by investing cash in marketable securities. This interest can also be called opportunity cost of cash.

The transaction cost of cash are the costs which are to be incurred to convert the marketable securities into cash. They include brokerage, accounting costs and cost of registration, etc.

There is an inverse relationship in both types of these costs. When cash balance increases, transaction cost decreases but carrying cost of cash increases. On the other hand, when cash balance is less, the transaction costs increase but carrying costs decrease.

The cash management model can be explained as under in the form of a formula. 


C = Optimum cash balance.

U = Annual or monthly cash disbursements.

P = Fixed cost per transaction.

S = Opportunity cost of one rupee p.a. or p.m.


Monthly cash requirements Rs.62,500

Fixed cost per transaction Rs.10

Interest rate on borrowing 12% p.a.

Calculate optimum cash balance. 

Cash Management – Control

The finance manager has to control the levels of cash balance at various units/divisions of the firm. This task assumes special importance on account of the fact that there is generally a tendency amongst divisional managers to keep cash balance in excess of their needs.

Hence, the finance manager should devise a system whereby each division of a firm retains enough cash to meet its day-to- day requirements without having surplus balance on hand.

For this, methods have to be employed to:

(a) Speed up the mailing time of payments from customers,

(b) Reduce the time during which payments received by the firm remain uncollected and speed up the movement of funds to disbursement banks.

Two very important methods to speed up collection process are:

(i) Concentration Banking, and

(ii) Lock- Box system

(i) Concentration Banking

A firm may open collection centres (banks) in different parts of the country to save the postal delays. This is known as concentration banking. Under this system, the collection centres are opened as near to the debtors as possible, hence reducing the time in despatch, collection etc.

The firm may instruct the customers to mail their payments to a regional collection centre/ bank rather than to the central office. The cheques received by the regional collection centre are deposited for collection into a local bank account.

Surplus funds from various local bank accounts are transferred regularly (mostly daily) to a concentration account at one of the firm’s principal banks. For effecting the transfer, several options are available.

With the vast network of branches set up by banks, regional/ local collection centres can be easily established. To ensure that the system of collection works according to plan, it is helpful to periodically audit the actual transfers by the collecting banks and see whether they are in conformity with the instruction given.

The concentration banking results in saving of time of collection, and hence results in better cash management. However, the selection of collection centres must be based on the volume of billing/ business in a particular geographical area. 

It must be noted that the concentration banking also involves a cost in terms of minimum cash balance required with a bank or in the form of normal minimum cost of maintaining a current account.

(ii) Lock – Box system

Under this system, customers are advised to mail their payments to special post office boxes called lock boxes, which are attended to by local collection banks, instead of sending them to corporate headquarters

The local bank collects the cheques from the lock box once or more a day, deposits the cheques directly into the local bank account of the firm, and furnishes details to the firm.

Thus the lock-box system (a) cuts down the mailing time, because cheques are received at a nearby post office instead of at corporate headquarters; (b) reduces the processing time because the firm does not have in open the envelope and deposit the cheque for collection and (c) shorten the availability delay because the cheques are typically drawn on local banks.

In India, the lock-box system is not popular. However, commercial banks usually provide service to their large clients to (a) collect cheques from the office of the client and (b) sending the high value cheques to the clearing system on the same day.

Both these services help reduce the float of the large clients. However, these benefits are not free. Usually, the bank charges a fee for each cheque processed through the system. The benefits derived I mm the acceleration of receipts must exceed the incremental costs of the lock box system, or the firm would be better without it.

When is it worthwhile to have a lock box? The answer depends on the costs and benefits of maintaining the lock box. Suppose that a firm is thinking of setting up a lock box.

The following information is available:

Average number of daily payments: 50

Average size of payment: Rs. 8,000

Saving in mailing and processing time: 2 days

Annual rental for the lock box: Rs. 3,000

Bank charges for operating the lock box: Rs. 72,000

Interest rate: 15%.

The lock-box will increase the firm’s collected balance by:

50 items day x Rs.8,000 per item x 2 days saved : Rs. 8,00,000. The annual benefit in the form of interest saving on account of this is: Rs. 8,00,000 x 0.15 = Rs. 1,20,000

The annual cost of the lock box is Rs. 3,000 (rental) + Rs. 72,000 (bank cheques): Rs.75,000

Since the interest saving exceeds the cost of the lock box, it is advantageous to set up the lock box. More so because the firm also saves on the cost of processing the cheque internally.

Cash Management – Management of Cash Flows: Accelerating Cash Collections and Slowing Down Cash Payments

After estimation of cash flows, the finance manager’s job is to ensure that there is no more deviation between the projected cash flows and the actual cash flows, which is a must for efficient cash management. 

Financial management should have the control on cash receipts and cash disbursements. The objectives of cash management is to accelerate cash receipts as much as possible and/or delay cash payments as much as possible.

In other words, the various collection and disbursement methods can be employed to improve cash management and efficiently constitute two sides of the same coin. Both collections and disbursements exercise a joint impact on the overall efficiency of cash management. 

The idea is speed collection of accounts receivables, so that the firm can use money sooner, otherwise, it has to borrow money, wherein costs are involved.

Conversely, firms want to pay accounts payables as late as possible without affecting credit standing, so that the firm can make use of the money it already has. Hence, for efficient cash management the firm has (A) to collect accounts receivables as early as possible, and (B) it has to delay the accounts payables without affecting credit standing.

(A) Accelerating Cash Collections:

Accelerating (speedy) cash collections can conserve cash and reduce its requirements for cash balances of a firm. Cash inflow process can be accelerated through systematic planning.

The following are the methods of accelerating cash collections:

1. Prompt Billing and Cash Discount:

In speed collection the first hurdle could be the firm itself. It may take a long time to process the invoice. Prompt payment by customers will be possible by prompt billing. The seller has to inform customers about the amount of payment and period of payment in advance.

Automation of billing and enclosure of self-addressed enveloped, will be helpful for speed payment of cash. The other way of prompting customers to pay earlier is to offer cash discounts. Cash discounts help customers save money and it would be easier to avail the discount.

2. Minimising Deposit Float:

After using cheques by the customers in favour of the firm collections can be quickened. Conversion of cheques into cash is the second hurdle. There is a time lag between the time a cheque is being prepared by the customer and the time the funds are credited to firm’s account.

There are three steps involved here, viz:

(i) Mailing time – The time taken by the post offices in transferring the cheques from the customer to the firm. The time lag is referred to as “postal float”.

(ii) Lethargy – Time taken in processing the cheques within the company and sending them to the bank for deposit and

(iii) Bank Float – The time taken by the bank in collecting the payment from the customer’s bank.

The postal float, lethargy and bank float – collectively known as “deposit float”. To quote Rama Moorthy, deposit float as the sum of cheques written by the customer that are not yet useable by the firm. In India, deposit float can assume sizeable opportunities as cheques normally take a longer time to get realised than in most countries. Accelerated collection of cash is possible when a firm reduces the transit, lethargy and bank float.

How can the deposit float be reduced?

It is possible through the options of a decentralised collection policy. There are three important methods available to use in a decentralised collection network, they are – (i) concentration banking, (ii) Lock-Box system, and (iii) Payment by wire.

(i) Concentration Banking or Decentralised Collections:

A firm operating its business spread over a vast area and its branches located at different places would do well to decentralise its collections. The decentralised collection procedure in the US is called as “Concentration Banking.” Concentration banking is a system of operating through a number of collection centres, instead of a single collection centre centralised at the company’s head office premises.

Under this system, a firm will have a large number of bank accounts in the operated areas, but all the areas may not have collection centres. Opening of a separate collection centre depends on the volume of business. In this system, the customers are instructed to send their payments to the collection centre covering the area under which they come and these are deposited in the local account of the concerned collection centre.

On realisation of the proceeds of the cheques, these may be remitted for credit to the Head Office Account, by way of telegraphic transfer, daily or weekly, as per the quantum of collections and the local requirements of funds for expenses. Hence, concentration banking reduces float, which saves time and reduces the operating cash needs. This system should be adopted only when the savings are higher than the cost.

(ii) Lock-Box System:

This is another technique of accelerating collection of cash. It is more popular in the USA and European countries. Under this arrangement, a firm rents post office boxes and authorises its bank to pick up remittances in the box. The boxes will be placed at different centres on the basis of number of consumers. Customers are billed with instructions to mail remittances to the box.

The local authorised bank of the firm, at the respective places picks up the mail several times a day and deposits the same into the firm’s account. After the collection of cheques the bank sends a deposit slip along with the list of payments and other required enclosures. But nowadays banks provide daily record of receipts collected usually via an electronic data transmission system.

Advantages of Lock-Box System:

The bank handles the remittances prior to deposit float at a lower cost.

Costs of Lock-Box System:

Lock-box system involves cost, since the services provided by the bank are chargeable or requires to maintain a minimum cash balance that involves an opportunity cost.

A financial manager has to compare the benefits derived from use of lock-box system and when benefits are higher than the cost involved then it should be adopted.

(iii) Payment by Wire:

This is another technique which is working with the help of information technology (IT). Under this system companies are increasingly demanding customers (larger bills) to pay by wire, or automatic electronic debts. In this technique funds are transferred from one account (debit) to another account (credit) at high speed, which is ultimate in the collection process. It is feasible and efficient.

(B) Slowing Down Cash Payments:

Operating cash requirement can be reduced by accelerating cash collections and slowing down cash payments. Increased availability of cash depends on the combination of speed collections and slow payments.

Following methods can be used to slowing down the payments:

1. Paying on the Last Date:

A prudent businessman would always prefer to make the payment only on the last day, when it is due and never earlier. But early payments entitles a firm to cash discounts. If there is no discount offer, early payments of accounts payables has no advantage, but if delayed beyond trade credit period, it affects the firm’s credit standing that makes it difficult to get trade credit in future. Hence, a firm would be well advised to pay payments only on the last dates.

2. Centralised Payments:

Under this system all payments are made from one central place that is Head Office.

The benefits of centralised payment system are:

a. It increases the transit time. Payment from a centralised place takes more time to send the cheques to customers.

b. Reduction in operating cash requirement since the firm has a centralised bank account, a relatively smaller total cash balance will be needed.

c. Controlled schedules and payments made exactly on the last day.

3. Paying the Float:

Float is the amount of money tied up in cheques that have been written, but have yet to be collected. Put it simply, float refers to the difference between the balance in firm’s cash book (bank column) and balance in passbook of the bank. There is a time lag between issue of cheque by the company and its presentation of cheque to the bank by the customer’s bank for collection of money, where cash is required later when the cheque is presented for collection.

So, the firm can issue a cheque without having sufficient cash in its bank account at the time of cheque issue to its customers, because at the time of presentation of the cheque for encashment, the firm can arrange for funds. Use of float in this way is referred to as cheque kiting.

Cheque kiting can be done in two ways:

(a) Paying from a distant bank and

(b) Cheque encashment analysis.

(a) Paying From a Distant Bank – as discussed in centralised payments

(b) Cheque Encashment Analysis – on the basis of the firm’s past experience (if firm has been paying from a few years onward), it can find out the lag in the issue of cheques and their encashment. If more time lag is there then the firm has to pay with delay and vice versa. It will help the firm to save cash.

Cash Management – Impact of Inflation on Cash Flow 

Inflation is growth in value terms and, therefore, in periods of rapid inflation, a firm should expect to find itself in a very unfavourable cash flow position, like that of the firm which is growing very fast. “In the words of W.C.F. Hartley, advance terms, it comes dangerously close to compounding a felony.” 

Timing of Cash Flow: 

When business is of a seasonal nature, cash inflows may vary from one period to another. Fig. 34.2 indicates the variations during the different periods of three different firms with identical cash balances at the beginning and at the end of the year, but with vast differences of cash flow. 

Most amounts are two-dimensional, viz., a quantity multiplied by a price. Cash flow amounts possess the perverse third dimension of time; and indeed, it is the time dimension which is at the root of the various problems created by accounting concepts. Therefore, in the long-term, profits are aimed at; but in the short-term, the cash flow is much more important.


There are environmental constraints which create cash flow problems for a firm. Such problems may be created by the very nature of its operations, such as the location or seasonality of the market place. Every firm should, therefore, examine its own position in respect of its environment which will affect its short-term flow.

Managerial Decisions:

A cash flow does not flow of its own accord. It is a direct consequence of management decision.

The management procedures employed for maximising the use of cash through the control of payables and related payments are:

(i) Timing payments to vendors so that bills are paid only as they fall due;

(ii) Establishing procedures which will prevent or minimise the loss of discounts;

(iii) Centralising payable and disbursement procedures;

(iv) Reducing compensating balance: on deposit with banks;

(v) Improving control over inter-company transfers;

(vi) Utilising facilities very efficiently;

(vii) Using manpower more effectively; and

(viii) Strategic tax planning.

It is said that “a fool and his money are soon parted. The rest of us wait until tax time.” This need not be so if a management uses strategic tax planning to minimise its tax expenditure.

Currently, a management employs the following techniques to reduce its tax payment:

(a) It uses accelerated depreciation method or adopts guideline depreciation rates;

(b) It uses investment credit to full advantage by strategic acquisitions and dispositions of property, plant and equipment;

(c) It deducts research and development costs and similar expenses in the years in which they are incurred instead of capitalising them and amortises such costs over a number of years;

(d) It adopts changes in accounting procedures, particularly those initiated by the Internal Revenue Service, or exploits changes in reporting periods.

Capital lent for short periods can be used only for short-term requirements. Therefore, when deciding the capital structures, it is necessary not only to know cash requirements but also to have them analysed according to the periods over which they will be needed.

A very quick and smooth circular flow of current assets tends to avoid serious liquidity problems, for it implies quick payment and collection of debts. But where the flow is not so quick and particularly where it is uneven, the financial management may have to be very adroit to avoid running into difficulties.

Businesses whose receipts tend to be uncertain and mercurial and which flow in a considerable period after the related expenses have to be paid, are particularly vulnerable to financial crises.

Cash Management – Money Market Instruments: Units of MFs, Ready Forward, Treasury Bill, Commercial Papers and More… 

Money Market Instruments (Marketable Securities):

Money market refers to the market for short-term securities. It has no physical marketplace and it consists of a loose agglomeration of banks and dealers linked together by telex, telephones and computers. A huge volume of securities is regularly traded on the market and the competition is energetic.

The following are the most prominent short-term securities available for investment of surplus cash:

1. Units of MFs:

In India there are more Mutual Funds (MFs) where surplus funds can be parked, by participating in open ended schemes.

Open-ended schemes comprise the following features:

(i) It can be purchased and sold back to the MF itself on a continuous basis,

(ii) The units have face value of Rs.10 the sale and purchase of units are not determined on the basis of the Net Asset Value (NAV) of the units, as should be the case for a truly open-ended scheme. It is instead determined administratively by the MF taking into account the element of accrued interest, from time to time, usually at monthly intervals.

Thus, the units of the MFs scheme offer a convenient and attractive investment avenue for short-term funds for the following reasons:

(a) Existence of active secondary market,

(b) Units appreciate over time in a fairly predictable manner as the MF makes a gradual upward revision in its selling and repurchase price from July to June, each year.

2. Ready Forward (RPs or Repos):

In the ready forward deal, a commercial bank or some other organisation may enter into an arrangement with a company, intending to park its surplus funds for a short period, under which the bank may sell some securities to one company and repurchase the same securities at prices (i.e., both buying and selling prices) determined and mutually agreed. Hence, it is termed as ‘ready forward’. Ready forwards, are however permitted only in a limited number of specified securities.

Ready forward does not provide any income to the company in the form of interest, but the company’s income is the difference between the buying and selling prices. The income earned on the ready forward is taxable as usual. The rate of return on a ready forward deal is closely related to the market conditions prevailing in the money market, which is generally tight during the busy season, also at the time of the annual closing.

3. Treasury Bill:

Treasury bills are the obligations of the Government for a short-term period of less than one year, ranging from 91 days to its multiple like 182 days and 364 days. They are sold at a discount rate and redeemed at the face value and the difference between the rates constitutes the income on them. In other words, they are not issued at any interest rate.

The yield on treasury bills is low, when compared to other gainful short-term investment avenues. But it has several attractive features, like – First, they are issued in a bearer form, which makes them easily transferable by mere delivery of the documents, without any endorsement.

Second, the secondary market for bills make them highly liquid, and also allows purchase of bills with very short maturities. Third, they are risk-free since they are having financial backing of the government.

4. Commercial Papers (CPs):

Commercial paper is short-term, unsecured promissory note issued by large companies. It was introduced in 1990 with a view to enable the highly rated corporate borrowers to diversify the sources of their short-term borrowings, as also provide an additional instrument to the investors, to park their surplus funds for a short period.

Eligibility, of any firm which is planning to issue commercial papers has to fulfil the guidelines given by RBI, such as –

(i) The tangible net worth of the issuing company should not be less than Rs.4 crore, as per latest balance sheet,

(ii) The company should have been sanctioned a working capital limit by the bank(s) or all India Financial Institutions (IFIs),

(iii) The company should have been classified as a Standard Asset by the financing bank(s) financial institutions, and

(iv) A minimum credit rating of P-2 of CRISIL (Credit Rating Information Services of India Limited), or such equivalent rating by any other agency approved by RBI (like ICRA – Investment Information and Credit Rating Agency of India Limited, CARE – Credit Analysis and Research Limited).

Mode of Issue:

Commercial papers can be directly (companies with high credit rating) issued or through dealers. These are generally sold at a discount (in bearer form) to the face value, as determined by the buyer, but sometimes they can be issued carrying interest and made payable to the order of the investor. Commercial paper should not be underwritten or co-accepted.

They can be issued with a maturity of a minimum period of 15 days (reduced from 30 days) to a maximum period of up to one year. They are issued in the denomination of Rs.5 lakh or multiples thereof. Any single investor has to invest a minimum amount of Rs.5 lakh.

The main attraction of CPs is the interest rate that is typically higher than that offered by the treasury bills or certificates of deposits. The only disadvantage is that it does not have an active secondary market.

5. Certificate of Deposit (CDs):

Certificate of deposit represents the receipts of funds deposited with a bank for specified period, like the bank term deposits, but the only difference is CDs are negotiable. CDs may be issued in registered form or bearer form. The later form is more popular since, it can be transacted more easily in the secondary market. Not like treasury bills (issued at discount) CDs are issued at an explicit rate of interest. On maturity, the investor gets the principal amount along with interest accumulated.

Certificate of deposits are popular form of short-term investment of surplus funds for companies due to the following reasons:

(i) These can be issued by banks in the required denominations and maturities period suits the needs of investors,

(ii) CDs are fairly liquid,

(iii) They are virtually risk-free and

(iv) CDs generally offer higher rate of interest then the treasury bills and even bank term deposits.

6. Banker’s Acceptance:

Banker’s acceptances are time drafts drawn on a bank by a firm (the drawer or exporter) in order to obtain payment for goods he/she has shipped to a customer which maintains an account with that specific bank. In other words, it is a short-term promissory trade note for which a bank (by having ‘accepted’ it) promises to pay the holder the face amount at maturity.

The draft guarantees payment by the accepting bank at a specific point of time. Hence, the acceptance becomes a marketable security. The document is not issued in specialised denominations, since one party uses acceptances to finance the acquisition of goods. The size of bank acceptances is determined by the cost of goods being purchased.

They serve a wide range of maturities and are sold on a discount basis, payable to the bearer. There is no secondary market for acceptances of large banks. Due to their greater financial risk and lesser liquidity, acceptances provide investors a yield advantage over treasury bills of same maturity. Acceptances of major banks are safe investment.

7. Inter-Corporate Deposits (ICDs):

This is a popular short-term investment avenue for companies in India. As the name itself suggests, an inter-corporate deposit is that deposit made by one corporate body (company) with another corporate company. The deposits are usually made for a maximum period of six months.

There are Three Types of Inter-Corporate Deposits:

(i) Call Deposits – These types of deposits are expected to be paid on call, which is whenever its repayment is demanded. Generally, these deposits are called back giving a day’s notice. But in actual practice the lender has to wait for at least three days.

(ii) Three-month Deposits – These are more popular among the corporate bodies for parking the surplus funds correspondingly for tiding over the short-term financial crunch faced by some others.

(iii) Six-month Deposits – Generally, inter-corporate deposits do not extend beyond six months period. This type of deposits is usually made with ‘A’ category companies only.

Inter-corporate deposits are in the nature of unsecured deposits. Hence, due care has to be taken to assess and ascertain the creditworthiness and willingness of the company concerned, with whom it is intended to be made.

In addition, it must make sure that it adheres to the following requirements, as stipulated by Section 370 and 372 of the Companies Act, 1956, (i) a company cannot lend more than 10 percentof its net worth without the prior approval of the Central Government and a special resolution permitting such excess lending.

8. Badla Financing:

A company providing badla financing is essentially lending money to a stock market operator who wishes to carry forward his/her transaction from one settlement period to another. Generally, such finance is provided through a broker and that too against the security of the shares already brought by the stock market operator.

Badla has the single greatest advantage that it offers very attractive rate of interest. But it is coupled with gain there are several risks like the stock market broker may not honour his/her commitment, or the broker may become a defaulter.

So the following precautionary and safety measures should be borne in mind while providing badla financing:

(i) Provide finance only for reputed and financially strong stockbroker,

(ii) Select intrinsically sound shares,

(iii) Ask or keep adequate margin, if share is highly volatile,

(iv) Secure possession of share certificates.

9. Bills Discounting:

Generally, bills arise out of trade transactions. Bill is drawn by the seller (drawer) on the buyer (drawee) for the value of goods delivered to him. During the pendency of the bill, if the seller needs funds he/she may get it discounted. On maturity the bill is presented to the drawee for payment.

A bill of exchange is a self-liquidating instrument. Discounting is superior to inter-corporate deposits. While participating in bill discounting a company should ensure that the bill is a trade bill and not an accommodation bill, try to go for bills backed by letters of credit rather than open bills as the former are more secure.

Cash Management – Strategies 

The fundamental goal in managing cash is to minimise unproductive or idle cash balances.

For accomplishing this goal the finance manager should formulate strategies of cash management in the following four areas:

(i) Projection of cash surplus or deficit for each period of planning horizon.

(ii) Determining optimal level of cash holding in the company.

(iii) Formulating strategy for economising cash by accelerating cash inflows or decelerating cash outflows.

(iv) Allocation of funds between cash and near cash assets.

We have already discussed that the cash budget and proforma statements are employed as tools for planning cash inflows and outflows. 

The remaining three aspects of the above strategies will be dealt with in the following paragraphs:

1. Determining Optimal Level of Cash Holding in the Company

One of the basic responsibilities of a finance manager is to maintain sufficient liquidity of resources so that current obligations of a company are settled at the proper time. Determining the appropriate level of cash balances involves fundamental decisions with respect to the company’s liquidity and its cash payables. Such decisions are influenced by a tradeoff between risk and profitability.

A business enterprise carries stock of cash primarily for transaction purposes and builds up secondary reserves (investment in highly liquid riskless securities) to meet precautionary and speculative motives. As already observed, since cash flows cannot perfectly be synchronised, some stock of cash is needed to cover the likely gap between cash inflows and cash outflows.

With the help of a cash budget the finance manager predicts the inflows and outflows of cash during some future span of time and thereby determines the cash requirements of the company. 

In the light of various factors influencing the amount of cash holdings such as terms of purchase and sale, collection period of receivables, credit position of the enterprise, the company’s products etc., appropriate level of cash, which the company should hold is decided.

Appropriate level of cash represents the level at which the company has to take recourse to additional borrowing of cash or to liquidate a part of its investment portfolio. It will, therefore, be equal to the total of transactions balance plus the safety stock necessary to satisfy precautionary requirements.

In many other companies having banking relations compensating balance requirements of a bank essentially decide the minimum level of cash. Compensating balances are required by commercial banks for several reasons. It is a way to increase the effective rate of interest even though many bankers deny that this is the real reason.

Business concerns must carry balances at the lending bank. Loans cannot be granted unless bankers have deposits. These balances constitute the earning base of banks. Banks earn most of their income by utilising the customer’s balances in the form of loans.

Banks render various useful services to their customers. They calculate, in the first instance, the cost of these services and then the average balances that would be necessary to provide enough return to compensate the cost.

For example, if a bank calculates that it would cost, on an average, Rs. 5,000 to the bank in providing service to a customer, the bank would insist on account balance, say Rs. 50,000 below which the actual balances must never fall, or a minimum average balance over a period of time, say Rs. 25,000 during a month.

Method of determining the compensating balances differs from bank depending on the earning rate, cost of the services and method of accounting analysis. In view of this, a prudent finance manager chooses a bank that requires the lowest compensating balances.

2. Inventory Model of Cash Management

In determining the optimal level of cash of a company, the Economic Order Quantity (EOQ) model is used in the standard inventory situation.

According to this model, the optimal level of cash is one at which the cost of carrying the inventory of cash and cost of going to the market for satisfying cash requirements is minimum.

The carrying cost of holding cash refers to the interest foregone on marketable securities whereas the cost of going to the market means the cost of liquidating marketable securities in cash.

Optimal level of cash can also be determined algebraically.

The following formula is used for the purpose: 

Illustration – 

Jackson Company Limited estimated cash payments of Rs. 40 lakhs for a one-month period. The average fixed cost for securing capital from the market is Rs. 100 and the interest rate on marketable securities is 12 percent per annum or 1.0 percent for the one month period. What is the economic order size of cash?


Economic order size of cash in this instance will be: 

The optimal transaction of the company is Rs. 2,82,487.

Inventory model of cash management is based on the following assumptions:

(i) The demand for cash, transaction costs of obtaining cash and the holding costs for a particular period are given and do not change during that period.

(ii) There is a constant demand for cash during the period under consideration.

(iii) Cash payments are predictable.

(iv) Bankers do not impose any restrictions on firms in respect of maintenance of minimum amount of balance in the bank account.

The EOQ approach to determination of optimal size of cash inventory is beset with several practical difficulties. One such difficulty is related with determination of fixed cost associated with replenishing cash. The fixed cost consists of both explicit cost and implicit cost.

The explicit cost represents interest rate at which includes the time spent by the treasurer or other official in placing an order for getting financial assistance, the time taken in recording the transaction, the secretarial time needed to type the transaction and the purchase order, and the time needed to record the safe-keeping notification. While explicit cost is determinable, it is very difficult to compute implicit cost.

The major limitation to the use of the EOQ model is that it assumes a constant rate of inflow and outflow per period. Where the situation is expected to steady this model is applicable.

However, where cash flows are of stochastic nature (irregular), the model may not be very useful. In such a situation other models should be used to determine the optimal size of cash inventory. One such model has been provided by Miller and Orr which incorporates a stochastic element.

3. Stochastic Model

This model is based on the basic assumption that cash balance changes randomly over a period of time both in size and direction and form a normal distribution as the number of periods observed increases.

The stochastic nature of cash balances resembles that shown in figure below:

The model prescribes two control limits – upper limit and lower limit. When cash balances reach the upper limit a transfer of cash to investment account should be made and when cash balances reach the lower point a portion of securities constituting the investment account of the company should be liquidated to return the cash balances to its return point.

The upper and lower limits of control are set after taking into account fixed costs associated with converting securities into cash and vice versa, and the cost of carrying stock of cash.

Miller and Orr have provided the simplest model to determine the optimal behaviour in a stochastic situation. The model is essentially a control- limit model designed to determine the time and size of transfers between an investment account and cash account.

The Miller Orr model specified two control limits designating ‘h’ for upper limit and I for the lower limit. The model is illustrated in the figure ahead.

According to the model when cash balances of the company reach the upper limit, cash equal to h-z should be invested in marketable securities (i.e., investment account) so that new cash balances touch z points.

If the cash balances touch I paint, the finance manager should immediately liquidate that much portion of the investment portfolio which could return the cash balance to z paint.

It may be interesting to note that cash balances are allowed to wander in h, z space and no control is called for so long as the cash balances stay there. The model sets ‘z’ as the target cash balance level, z and h, therefore, become levels determined to maximise profits.

The optimal value of z is determined by the following formula: 

There are practical problems involved in the application of this model. First such problem is in respect of collection of accurate data about transfer casts, holding casts, number of transfers and expected average cash balance.

Secondly, there is no objective basis to determine the cost of time devoted by managers in dealing with the transfers from cash to securities and vice versa.

Subjective judgement is also involved in determining the lower limit of cash because while determining the lower level, management must consider the magnitude of fluctuations in cash balances, cost of being out of cash and the degree of uncertainty and these factors are subject to personal judgement.

Another drawback of this model is that it does not take cognizance of short-term borrowing as an alternative to selling of marketable securities when cash balances reach the lower limit.

In sum, it may be observed that the model when applied to real life situations (Union Tank Car Company) produced considerable cost savings. However, the control-limit models, according to Miller and Orr, “should not be thought of as something fundamentally different from ordinary management principles or techniques.”

These are essentially extensions of the fundamental notion of “management by exception.” The model, like other models, helps in providing more, better and speedier information for management of cash.

4. Probability Model

Probability model for controlling cash was developed by William Beranek. While presenting his model Beranek observed that cash flows of a firm are neither completely predictable nor stochastic. Rather they are predictable within a range. This occurrence calls for formulating the demand for cash as a probability distribution of possible outcomes.

In probability models, a finance manager has to estimate probabilistic outcomes for net cash flows on the basis of his prior knowledge and experience. He has to determine what is the opening cash balance for a given period, what is the expected net cash flow at the end of this period and what is the probability of occurrence of this expected closing net cash flow.

Probability model seeks to determine the optimum level of cash balance that a firm should have at the beginning of the planning period (a week or a month) with the help of the probability distribution of net cash flows; cost of cash shortages, opportunity cost of holding cash balance and the transaction cost.

The optimum cash balance level at the start of each planning period is such that:  

The decision rule which the model prescribes for a finance manager is that he should go on investing in marketable securities from the opening cash balance until the expectation that ending cash balance will be below the optimum cash balance where the ratio of the incremental net return per rupee of investment is equal to the incremental shortage cost per rupee.

The model is based on the following assumptions:

1. Cash is invested in marketable securities at the end of the planning period, i.e., a week or a month.

2. Cash inflows take place continuously throughout the planning period.

3. Cash inflows are of different sizes.

4. Cash inflows are not fully controllable by the management of a firm.

5. Cash disbursements take place on certain days because the management is able to control the majority of the disbursements for a given planning period.

6. A finance manager can prognosticate a firm’s need for a given planning period and can use a part of cash, not required during the planning period, to buy marketable securities.

7. Sales of marketable securities and other short-term investments will be effected at the end of the planning period.

The pattern of cash balance behaviour based on the above assumptions is figured out in Figure below: 

Cash Management – Cash Budget: Meaning, Necessity and Preparation       

Meaning of Cash Budget:

Cash Budget is the forecast of cash position for a particular period cash budget is prepared after all the functional budgets are prepared. It is probably the most important device for planning and controlling the use of cash. It aims at maintaining adequate cash balances to meet all the obligations but at the same time avoiding excessive balances. Cash budget is prepared either weekly or monthly.

Why it is Necessary:

(1) To get the working capital easily from the banks and for smooth running of the business.

(2) To enable the top management to make necessary arrangements of cash in case of emergency.

(3) To invest excess cash.

(4) To know the exact amount of cash required for the business.

Preparation of the Budget:

There are 3 methods of preparing the cash budgets:

(i) Receipts and payments Method

(ii) The adjusted profit and loss Account Method and

(iii) The balance sheet Method.

(i) Receipts and Payment Method 

In this method, all the cash receipts which are expected and all the cash payment which are expected to be made are taken into account thus the cash balance will represent the difference between the total cash receipts expected (including the opening cash balance) and the total cash payments to be made.

(ii) The Adjusted Profit and Loss Account Method

Under this method budgeted profit is taken as the basis from this funds from which operations are ascertained.

Then the availability of cash during budget period is calculated as follows:

(iii) The Balance Sheet Method 

Under this method, the cash balance is excluded. The two sides of the balance are balanced and the balancing figure then represents cash balance or bank-overdraft. 

This method is useful for long term forecasting of cash for the year. The disadvantage of this method is that it shows only the end of the budgeted period. It does reveal the cash position occurring within the budgeted period.

Cash Management – Cash Budget: Purpose, Preparation, Problems and Solutions

Cash budget has proved to be of great help and benefit in the following areas:

1. Estimating cash requirements

2. Planning short-term finance planning

3. Scheduling payments, in respect of acquiring capital goods

4. Planning and phasing the purchase of raw materials

5. Evolving and implementing credit policies

6. Checking and verifying the accuracy of long-term cash forecasting.

Preparation of Cash Budget (Elements of Cash Budget):

The above benefit areas are clear that the main aim of preparing cash budget is to predict the cash flows over a given period of time and to determine whether at any point of time there is likely to be a surplus or deficit of cash.

Preparation of cash budget involves the following steps:

Step 1- Selection of Period of Time (Planning Horizon):

Planning horizon is that period for which cash budget is prepared. There are no fixed rules for the period of cash budget preparation. Planning horizon of a cash budget may differ from firm to firm, depending upon the size of the firm. Cash budget period should not be too short or too long. If it is too short many important events may come out in the planning period and cannot be accounted for the preparation of cash budget, which becomes expensive.

On the other hand, if it is too long the estimates will be inaccurate. Then how to determine planning horizon? It is determined on the basis of situation and the necessity of a particular case. A firm whose business is affected by seasonal variations may prepare monthly cash budgets.

If the cash flows are fluctuating in nature, daily or weekly cash budgets should be prepared. Longer period cash budgets may be prepared when the cash flows are stable in nature.

Step 2- Selection of Factor that has Bearing on Cash Flows:

The factors that generate cash flows are divided into two broad categories:

(a) Operating and

(b) Financial.

(a) Operating Cash Flows:

Operating cash inflows are cash sales, collection of accounts receivables and disposal of fixed assets and the operating cash outflows are bills payables, purchase of raw materials, wages, factory expenses, administrative expenses, maintenance expenses and purchase of fixed assets.

(b) Financial Cash Flows:

Loans and borrowings, sale of securities, dividend received, refund of tax, rent received, interest received and issue of new shares and debentures cash outflows are redemption of loan, repurchase of shares, income-tax payments, interest paid and dividend paid.

Illustration 1:

From the following information prepare cash budget for VSI Co. Ltd.

Illustration 2:

Prepare cash budget for the 3 months ending 30-06-2004 from the following information.

(d) Other Information:

(i) Machinery will be installed in Feb.’04 at a cost of Rs.96,000. The monthly installment of Rs.2,000 is payable from April onward.

(ii) Dividend at 5 percenton preference share capital of Rs.20,000 will be payable on May, the same is paid in 1st June.

(iii) Advance to be received for sale of vehicles Rs.9,000 in June.

(iv) Dividends from investments amounting to Rs.1,000 are expected to be received in June.

(v) Income-tax (advance) to be paid in June is 2,000.


2. 75 percent of the March + 25 percent of the previous month

3. 50 percent of the month + 50 percent of the previous month

Cash Management – Cash Cycle and Cash Turnover (with formula for Calculating Cash Cycle)

Cash Cycle

Cash cycle refers to the length of time between the payment for purchase of raw materials and the receipt of sales revenue. So, the cash cycle indicates the time that elapses from the point when the firm makes an outlay to purchase raw materials to the point when cash is collected from the sale of finished goods produced using those raw materials.

The cash cycle can be determined by using the following formula: 

Cash Turnover

Cash turnover refers to the number of times each year the firm’s cash is actually turned over. It indicates the effectiveness with which cash and bank balances have been utilized by the firm.

The finance manager should, therefore, make an attempt to reduce the duration of the cash cycle, so as to increase the cash turnover. If he succeeds in his attempt, then he can keep minimum cash and turn it over again and again to achieve the maximum volume of sales.

The cash turnover is calculated as follows: 

Cash Management – Formulating Strategy for Economising Cash: Strategy towards Accelerating Cash Inflows and Cash Outflows 

Once cash flow projections are made and appropriate cash balances are established, finance managers should take steps towards effective utilisation of available cash resources. A number of strategies have to be developed for the purpose.

These strategies fall into two broad categories, viz.:

(1) strategy towards accelerating cash inflows, and

(2) strategy towards accelerating cash outflows.

1. Strategy towards Accelerating Cash Inflows

A number of methods may be employed to speed up the cash inflows and maximise the available cash. The overall purpose of such various methods is to reduce the time lag between the moment a payment to the company is mailed, and the moment the funds are ready for redevelopment by the company.

This total lag represents the combined effect of three smaller lags: the time the payment is in the mail, the time required to clear cheque through the banking system, and the time required for the bank to report clearance to the company.

i. Quick Deposit of Customer’s Cheques:

One way of shortening the time lag between the date when a customer signs a cheque and the date when the funds are available for use is to make an arrangement for quick deposit of the cheques in the banks the moment they are received. Special attention should be given to large remittances.

For example, these may be deposited individually or air mail services should be used for such remittances.

ii. Establishing Collection Centres:

To accelerate the cash turnover, a nation-wide organization may, instead of a single collection centre, establish collection centres in various marketing centres of the country.

The customers are instructed to remit their payments to the collection centre of their region. The collection centre deposits the cheques in the local bank. These cheques are collected quickly because many of them originate in the very city in which the bank is located. Surplus money of the local bank can then be transferred to the company’s main bank.

Thus, with this decentralised system of collection the company stands to gain two main advantages. First, the time required to mail bills to customers is reduced because bills are handed over to customers by the collection centre of the area.

Again, the time the customer’s payments reach the company’s head office is also reduced because the collection centre will receive all the payments whether cash or cheques from the customers of its region.

Secondly, the decentralised system hastens the collection of cheques because most of the cheques deposited in the company’s regional bank are drawn on banks located in that area. Thus, the company can reduce the time a cheques takes to be collected.

Thus, if a company could reduce, say for example, two days – one day in mailing bill and one day in collection of cheques by adopting the decentralised system, and if the company’s average daily remittances amount to say Rs. 20 lakhs, funds of about Rs. 40 lakhs could be released for investment elsewhere. This would increase the profits of the company.

However, the company will have to incur additional cost to man these collection centres. An indepth cost-benefits analysis of each region, where the collection centre is to be set-up, should be undertaken by the company.

iii. Lock-box Method:

Another device which has become popular in the recent past is lock-box method which will help reduce the time interval from the mailing of the cheque to the use of funds by the company. Under this arrangement, the company rents lock-box from post offices through its service area.

The customers are instructed to mail cheques to the lock-box. The company’s bank branch picks up the mail from the lock-box several times a day and deposits them in the company’s account and on the same day sends the company by air mail the deposit slip listing all the cheques deposited.

Thus, the company is freed from the botheration of receiving, processing, endorsing and depositing remittance cheques and accordingly, overhead cost of the company is reduced to the extent. It takes less time under lock­box system in mailing cheques for deposit in bank and their collection.

Instead of going to the regional collection office and then to the bank, customer’s cheques go directly to the company’s bank via the lock-box. Another advantage of this arrangement is that it reduces the exposure to credit losses by expediting the time at which data are posted to ledgers.

However, the basic limitation of the lock-box system lies in additional cost which the company’s bank will charge in lieu of additional services rendered. Since the cost for these services is directly in proportion to the number of cheques handled by the bank, obviously the lock-box arrangement will prove useful and economical too when average remittance is large.

Before deciding to adopt the lock-box system the finance manager must compare the added income on funds released as a consequence of speedy collection of remittance with the increased cost entailed by the system. If the benefits are more than the cost, obviously the company should use the lock­box system otherwise the idea of employing the system should be dropped.

iv. Other Methods:

Cash balances lying idle in the company’s name in several banks could be minimised without any loss in banking services.

The most important measure that can be useful in this respect is to eliminate many such bank accounts as were originally opened and subsequently maintained just for building up strong image in the market.

Thus, with a few accounts in bigger banks having their branches scattered all over the country the company can handle customer’s cheques as effectively as earlier with several unnecessary accounts. By closing the superfluous accounts the company can release funds for investment in profitable channels.

Another device of improving the efficiency of cash utilisation in the company is to set a maximum limit which each bank of the company will maintain at one time. The banks may be given instruction that any balance in excess of the stipulated limit should be immediately transferred by the company’s principal bank.

The principal bank, in turn, may be instructed to invest funds in excess of the limit set for it in highly liquid riskless securities. Without jeopardising liquidity the company manages to increase its profits under the above arrangement.

The company should also tighten control over transfers of cash between its various units so that excessive funds are not tied up in some units.

2. Strategy Towards Slowing Cash Outflows

In order to optimise cash availability in the company finance manager must employ some devices that could slow down the speed of payments outward in addition to accelerating collections. We shall now discuss some of the important methods that may delay disbursements.

i. Delaying Outward Payment:

By delaying the payment on bills until the last date of the no-cost period, finance manager can economise cash resources. If purchases are made on terms of 1/10, n/30, this method suggests that payment could be made on the 10th day. In this way the company not only avails of benefits of discount but also releases funds for nine days for investment in short-term channels.

ii. Slowing Disbursement by Use of Drafts:

A company can delay disbursement by use of drafts on funds located elsewhere. Payments could be made through cheques but for that drawer of the cheque must have the funds in the bank. When a cheque issued by the enterprise is presented to the bank the firm’s bank balance is reduced.

Contrary to this, when a draft is issued, the bank will not make the payment amount of the draft unless the bank gets the acceptance of the issuer firm. Thus, the firm need not have balance in its bank account till the draft is presented for acceptance. If terms of trade is 2/10, n/30 the company can mail the draft to the supplier on the 10th day.

The supplier will present the draft to his bank for its presentation to the buying company’s bank. It will take several days for the draft to be actually paid by the company. Finance manager can thus economise large amounts of cash resources for at least a fortnight. The funds so saved could be invested in highly liquid low risk assets such as treasury bills to earn income thereon.

iii. Making Payroll Periods Less Frequent:

This can also help a company to economise cash. If the company is currently disbursing pay to its employees weekly, it can effect substantial cash savings if pay is disbursed only once in a month.

iv. Where Payroll is Monthly:

Finance manager should predict when employees will present cheques to the company’s bank for collection. Supposing, if pay day falls on Saturday not all cheques will be presented on that day. The company needs net deposit funds to cover its entire payroll.

Even on Monday, some employees may not present cheques for payment. So on the basis of past experience, the finance manager could estimate, on average, the cheques presented on pay day and on the subsequent day for payment. Accordingly, a finance manager can assess funds requirements to cover payroll cheques on different days.

v. Playing the Float:

Float is the difference between the company’s cheque book balance and the balance shown in the bank’s books of accounts. When the company writes a cheque, it will reduce the balance in its books of accounts by the amount of cheque. But the bank will debit the account of its customers only after a week or so when the cheque is collected.

Thus, there is no wonder if the company’s books show a negative balance while the bank’s book exhibits a positive balance. One way by which the company can improve its cash utilisation is to ignore its book balance and keep its cash invested until just before the cheques are actually presented for payment. This technique is known as ‘playing the float.’ 

vi. Centralised Payment System:

A centralised payment system is advisable for delaying payments. Under this system the payments of bills will be made from a single central account. It will take time for the payment to be collected from the firm. This will benefit the firm.

vii. Transfer of Funds from One Bank to Another:

In this method the company instructs its bank with the surplus cash balances to transfer it to another bank of the company where disbursements are to be made. This would prevent building up of excess cash balances in one bank. This strategy could be adopted by a company having accounts ‘with several banks.

Finance manager has to device a control system over incoming cash so that cash coming in the company is credited in the bank account and does not go in the pockets of its employees. Many fraudulent devices are employed to embezzle funds.

One such method, for example, may be to pocket the payments on accounts receivable and to write off the customer’s account as debt or to show that credit was given to the customer for goods returned.

The general approach to prevent such practices is to break up the receipt of cash inflows into several steps and responsibility for each is assigned to different employees.

Thus, one person might be assigned the responsibility of making necessary entries in the accounts receivable ledger, the other person might open the mail and enter the cheques in the register and another person might prepare the cheques for deposit.

This system will minimise cash leakages as the collusion between two or more employees is not so easy. Although this system may prove costly in small companies handling relatively low amounts of cash inflows during a period, it may prove less costly in the long run when compared with funds that would otherwise have gone in the pocket of a person handling the entire receipt work alone.

There is a need to have stricter control over outflows of cash as the scope of embezzlement exists there too. For example, payments might be shown in the books of account to have been made to suppliers who did not exist at all or funds might be withdrawn for fictitious purposes. Such a practice can also be controlled by dividing the disbursement procedure into several steps so that more than one person is involved.

Recent Developments in Cash Management

Due to technological development, the firm used to apply various innovative techniques for handling of cash. It is important to understand the latest developments in the field of cash management, since it has a great impact on how we manage our cash.

Both technological advancement and desire to reduce cost of operations has led to some innovative techniques in managing cash.

Some of them are as follows:

1. Electronic Fund Transfer:

With automation and computerisation of banking system, the corporate cash management has also tried to incorporate the advantages of automated fund transfers. Electronic fund transfer speeds up the cash receipt and reduces the cash transit.

This will help the customers in the following ways:

i. Instant updation of accounts

ii. The quick transfer of funds

iii. Instant information about foreign exchange rates.

Electronic fund transfer mechanism automatically transfers money from one account to another regularly. These systems reduce not only the transit float but also the float of the cash in the bank. It reduces the clearing period.

2. Zero Balance Account:  

For efficient cash management some firms employ an extensive policy of substituting marketable securities for cash by the use of zero balance accounts. Every day the firm totals the cheques presented for payment against the account. The firm transfers the balance amount of cash in the account, if any, for buying marketable securities. In case of shortage of cash, the firm sells the marketable securities.

3. Money Market Operations:

One of the tasks of treasury function of larger companies is the investment of surplus funds in the money market. The chief characteristic of money market banking is one of size.

Banks obtain funds by competing in the money market for the deposits by the companies, public authorities, high net worth investors (HNI) and other banks. Deposits are made for specific periods ranging from overnight to 1 year; highly competitive rates which reflect supply and demand on a daily, even, hourly basis are quoted.

Consequently, the rates can fluctuate quite dramatically, especially for the short-term deposits. Surplus funds can thus be invested in money market easily.

4. Petty Cash Imprest System:

For better control on cash, generally the companies use petty cash imprest system wherein the day to day petty expenses are estimated taking into account past experience and future needs and generally a week’s requirement of cash will be kept separate for making petty expenses.

Again, the next week will commence with the predetermined balance. This will reduce the strain of the management in managing petty cash expenses and help in managing the cash efficiently.

5. Electronic Cash Management System:

Most of the cash management systems nowadays are electronically based, since speed is the essence of any cash management system. Electronically, transfer of data as well as funds play a key role in any cash management system. Various elements in the process of cash management are linked through a satellite.

Various places that are interlinked may be the place where the instrument is collected, the place where cash is to be transferred in company’s account and the place where the payment is to be transferred, etc.

6. Virtual Banking:

Broadly virtual banking denotes the provision of banking and related services through extensive use of information technology without direct recourse to the bank by the customer. The origin of virtual banking in the developed countries can be traced back to the seventies with the installation of Automated Teller Machines (ATMs).

Subsequently, driven by the competitive market environment as well as various technological and customer pressure, other types of virtual banking services have grown in prominence throughout the world.

Introduction of computerised settlement of clearing transactions, use of Magnetic Ink Character Recognition (MICR) technology, provision of intercity clearing facilities and high value clearing facilities, Electronic Clearing Service Scheme (ECSS), Electronic Funds Transfer (EFT) scheme, Real Time Gross Settlement System (RTGS), Delivery versus Payment (DVP) for government securities transactions and setting up of Indian Financial Network (INFINET) are some of the significant developments.

Evaluation of Cash Management – With illustrating the Evaluation Process

The responsibility of a finance manager is not over with allocation of funds between cash and near cash assets. He has to evaluate the progress of work in respect of utilisation of funds in cash so as to ascertain whether funds are utilised in conformity with plans and policies laid down in respect thereof.

The evaluation process involves comparison of actual performance against predetermined plans and objectives, finding out discrepancy, if any, analysing these variations in order to pinpoint the underlying causes and finally, taking remedial steps to correct the anomaly so that the performance conforms to the plans and goals of the company. It is on this line that a finance manager should undertake the task of evaluating cash management.

In evaluating cash management the finance manager has to check actual receipts and payments against the projections and to determine the reasons responsible for deviations and take necessary steps to eliminate the deviations.

It is not necessary that actual receipts and disbursements will always coincide with what was estimated. Variations may result from factors affecting cash occurrence of unexpected events influencing receipts and payments and absence of effective control.

So as to ensure desired liquidity position such control procedures should be devised as may enable the finance manager to take prompt decisions and change the current policies so that deteriorating cash position may not be out of control.

Unforeseen change in budgeted cash position resulting in substantial cash drain in the company is not unusual. However, management, if informed timely, can save the company from any eventuality by taking prompt decisions in matters like aggressive efforts to collect receivables, reduction of out-of-pocket expenses, deferment of certain expenditures, postponement of payment of certain liabilities, pruning down purchases of materials and rescheduling timing of operations affecting cash.

This is possible only when periodic evaluation of the current cash position against projected position is made. This can be done with the help of cash budget report. The cash budget report contains information regarding actual receipts, and disbursements along with the corresponding budgeted figures and variations from projected figures. Such report is generally prepared for each month.

Next task of the finance manager is to undertake an in depth analysis of the causes of the variation. Budget variations may result either from real causes or by mistakes in estimating cash receipts and payments.

After analysing the causes of variances, the finance manager takes remedial action. Where the analysis discloses that the deviations were due to one or more of real causes, he has to ascertain whether the policies affecting cash were in conformity with objectives and if they are not then to revise the policies so as to align them with objectives and cash budget for the succeeding period should be versed and included in the cash budget report.

We can illustrate the evaluation process with the help of the following example:

Cash budget report of a company reveals a major decrease in cash in March, 2004 contrary to the expectation. On investigation it was noted that due to unexpected fall in demand sales dropped sharply. It is expected that the declining tendency would persist in the ensuing months.

The finance manager would examine each policy of the company affecting inventory, receivable dividend and investments to make changes therein to live with new situations. The policy changes that may be contemplated by the finance manager in account, reducing inventories by decreasing the purchases of raw materials and supplies, eliminating present commitments for the purchase of major assets which have not been delivered, reducing the current indebtedness.

In the light of these changes, new projections of cash receipts and expenditures will be made and these will be incorporated in the report. If the changes are such that additional financial resources are inadequate, provision has to be made to procure additional capital-on either a long or short-term basis.

Where budgetary errors have caused budget variances, the cash budget will have to be revised to eliminate errors instead of changing the policies and procedures. If forecasting was erroneous, the cash budget will have to be revised to rectify the miscalculation.

In case the balance was against the interest of the company, i.e., receipts were less than the disbursements, the finance manager should change policies affecting cash position in such a way as to increase cash balance.

However, if there was excess receipts over disbursements, the finance manager should recast the financial plan to take care of this balance. For that matter, cash dividends may be raised, idea of additional financing maybe dropped or investment programme may be revised.

Thus, evaluation of cash management not only calls for comparison of actual receipts and disbursements with the projections but also implies a complete replanning process in the form of revision of objectives, policies and procedures. This means that there should be continuous budget evaluation of the cash position so as to make possible continuous control through policy decisions.

Advantages of Cash Management

1. The availability of cash may be a matter of life or death. A sufficiency of cash can keep an unsuccessful firm going despite losses. Conversely, this insufficiency can bring failure in the face of actual or prospective earnings.

2. An efficient cash management through a relevant and timely cash budget may enable a firm to obtain optimum working capital and ease the strains of cash shortage, facilitating temporary investment of cash and providing funds for normal growth.

3. Cash may be said to be like the bloodstream in a living body; for it is very much the life-blood of business. It must be kept circulating around the arteries of the business because if the circulation gets clogged, sickness and death may occur, as they do when a clot forms in an artery.

4. The first priority of any business is survival, and this cannot be assured, even in the short run, unless a company remains both liquid and solvent, that is, unless it is able to pay its debts as and when they fall due, both immediately and in the foreseeable future.

5. Cash management involves balance sheet changes and other cash flows that do not appear in the profit and loss account such as capital expenditure.

6. It gives an inventory of the financial reserves which are available in the event of a recession.

7. It yields a plan as an integral part of the procedure.

8. It views problems in a dynamic context over a period of time.

9. It yields a number of additional insights into the crucial task of framing a sound debt policy. The focus is on the solvency of the firm in adverse circumstances rather than on the effects of leverage in normal circumstances.

10. While a regularisation of cash flows enables a management to achieve a more effective planning, sophistication in handling cash enables a firm to cut down on the amount that it must keep in order to sustain any given level of operations.

Problems Involved in Cash Management

The basic problems involved in the cash management are-

1. Controlling the Level of Cash:

One of the basic objectives of cash management is to minimize the level of cash balance. Controlling the level of cash balance is one of the basic problems of cash management. Cash balance should be neither excessive nor inadequate but adequate.

The cash level can be controlled through the following devices:

(i) Preparing the Cash Budget:

Preparation of cash budget is the most important device for controlling the level of cash balance. A cash budget is a summary of receipts and payments of cash for a defined period of time. It gives the details of cash receipts and cash payments and cash balance at the end of the every month or every week.

(ii) Procedure for the Preparation of Cash Budget:

First, the opening cash balance is taken as starting point.

Add all probable cash receipts during the budget period

Deduct all cash payments to be made during the budget period.

The resulting balance is the closing cash balance.

(iii) Estimating the Cash Receipts and Cash Payments:

(a) Estimating the Cash Receipts:

The important cash receipt is the sale of goods. Receipts from sale include cash sales and receipts from debtors for credit sale of goods. Receipts from debtors is estimated by taking in to account, amount of credit sales, sales returns, the period of credit allowed to debtors, the allowances and discount allowed to debtors, the bad debts if any.

(b) Estimating the Cash Payments:

The important cash payments are the payment for purchase of goods. Payment for purchase includes cash purchases and payments to creditors for credit purchase, payments to creditors for credit purchase of goods is estimated by taking in to account, amount of credit purchases, purchase returns, the period of credit availed from creditors, the allowances and discount received from creditors.

(iv) By Providing for Unpredictable Discrepancies:

Providing for unpredictable discrepancies is another device for controlling the cash balance with a firm. It means providing of sufficient cash balance for meeting the discrepancies between the cash inflows and cash outflows on account of unforeseen circumstances. This cash balance is determined based on experience and forecasting future events.

(v) Consideration of Short Costs:

Consideration of short costs is another device used for controlling the level of cash balance. Short costs refer to the costs incurred as result of shortage of cash. Short costs may comprise cost incurred in defending the suits filed by the creditors for the recovery of the amounts due to them high cost of borrowing to tide over the shortage of cash, penal interest for delayed payment to creditors, loss of cash discounts on account of the failure to pay the creditors in tome, loss of firm’s reputation etc.

(vi) By Arranging Funds from Other Sources:

By making arrangements for funds from other sources, particularly from banks during emergencies, a firm can avoid holding unnecessarily large cash balance.

2. Controlling the Cash Inflow:

Controlling the inflow of cash is another basic problems involved in cash management. Controlling the inflow of cash refers to speeding up of cash collection process. It can be solved through speedy collection of cash from customers. There are number of devices for a business organization to speed up its cash collection process.

They are-

(i) Proper System of Internal Check:

The business organization should design and introduce proper internal control system. Through proper system of internal check, embezzlement & defalcation of cash can be minimized.

(ii) Increasing the Cash Sales:

The cash inflows can be increased by increasing sales.

(iii) Concentration Banking:

It is one of the important devices used by large business concerns for speedy collection of cash from customers. It is a system of decentralizing collection of account receivables. Under this system, a large number of collection centers are established by the firm in geographical different areas.

The firm opens bank account in local banks of different areas where it has collection centers. The collection centers are requested to collect cheques from their customers and deposit them in the local bank accounts. The collection centers are also instructed to transfer funds over a certain limit daily to the bank at head office through telegraphic transfers. Thus, this system facilitates quick collections and fast movement of cash.

The system of concentration banking has certain advantages.

They are:

(a) The time involved in collecting the cheques from the customers and in depositing them in to the bank is reduced, since the collection centers themselves collect the cheques from the customers and immediately deposit them in to the local banks.

(b) The time required to realize or collect the cheques deposited in to banks is also reduced, as the cheques deposited into the local banks for collection are usually drawn on banks in that area.

(c) The mailing time in sending the bills to the customers can be reduced, if the local centers are also authorized to prepare and send the bills to the customers.

(iv) Lock Box System:

Lock box system is another important device used by large business concerns for speedy collection of cash from customers. Under this system firm hires lock boxes from post offices in various areas and instructs its customers to mail their remittances to the lock box or post office box in their area.

The firm’s local bank is authorized to pick up mails several times a day and deposits the cheques in the firm’s current account. The firm’s local bank is also instructed to transfer the funds to the head office bank through telegraphic transfers, when they exceed a certain limit. Thus, this system facilitates quick collections and fast movement of cash.

3. Controlling the Cash Outflow:

Controlling the outflow of cash is another basic problem in cash management. Control of cash outflows refers to decelerating or slowing down the cash payment process. So the business organization can keep cash for some more time without inviting any trouble.

The following are the important methods to slowdown the cash payment:

(a) Centralized Payment System:

Under this system, all payments should be made from a single control account. This will result in delay in presentment of cheques for payment by parties who are away from the place of control account.

(b) Payments Only On Due Dates:

Payment should be made only on the due dates, neither earlier nor later. The firm should lose neither cash discount nor its prestige because of delayed payments.

(c) Technique of Playing Float:

The firm may use the technique of playing float for maximizing the availability of funds. The term float refers to the amount tied up in cheque that have been issued, but not been presented for payment. There is always a time lag between the issue of cheque by the firm and its actual presentment for payment. This time gap is called float period.

(d) Delaying the Salary or Wages:

A business organization may follow the practice of paying the salaries or wages for the month in the first or second week of next month instead of paying on the last day of the month or on the first day of the next month. By this practice, the organization can keep cash for one or two weeks without a problem.

4. Investing Surplus Cash:

There are two basic problems regarding to this.

They are:

i. Determination of the amount of surplus cash

ii. Determination of the channels of investment.

i. Determination of the Amount of Surplus Cash:

Surplus cash refers to the cash in excess of the firm’s normal cash requirements. The firms surplus cash is ascertained by taking in to account the safety level of cash.

Safety level of cash refers to the minimum cash balance that a firm must keep to avoid the risk or cost of running out of cash. The safety level of cash can be determined by taking in to account the number of days for which cash balance is required to be held and the average amount of daily cash payments.

ii. Investment of Surplus Cash:

Surplus cash may be temporary or permanent. Temporary cash surplus refers to the surplus cash available for a short period of not more than 6 months. Permanent cash surplus refers to surplus cash available for a period ranging from 6 months to one year. If the surplus cash is temporary it may be kept in banks in short term deposits for 15 days or more or invested in marketable securities. If the surplus cash is permanent, it may be utilized for repayment of long-term loans or for expansion.

While investing the surplus cash a firm takes in to consideration the following factors:

(a) Security – Investing the surplus cash on safe assets

(b) Liquidity – Investing the surplus cash on liquid assets

(c) Yield – Investing the surplus cash on high yield assets

(d) Maturity – Investing the surplus cash on early-matured assets.

Cash Management – Allocation of Funds between Cash and Near Cash Assets 

Before discussing the principles of allocation of funds between cash and near cash assets, a clear understanding about near cash assets i.e., short-term highly liquid securities is inevitable. Short-term highly liquid securities represent highly liquid earning assets which may be converted into cash without delay and appreciable loss.

These assets are collectively designated as secondary reserves. The major function of Secondary reserve is to replenish the cash (also called primary reserve). Thus, the secondary reserve comprises all such securities as carry comparatively little risk, nevertheless yield on these securities is less.

The basic principles governing allocation of funds between cash and near cash assets are:

Principle # a. Marketability:

The prime requisite of the near cash assets is that they can be liquidated as and when required to replenish cash. This means that only those securities should be chosen for investments which are easily saleable even for large amounts without appreciable reduction in their prices. Such securities can be depended on to meet cash shortages.

Principle # b. Safety in Assets:

It means immunity from credit risk, i.e., risk arising out of default of the debtors in payment of principal or interest or both.

The credit risk is a product of the character of the debtor, the economy which supports the obligations and the borrowing power of debtor. Securities of the Central Government are regarded as gilt-edged securities, as they are free from credit risk because of the great tax and borrowing powers and greatness of the economy from which it derives its funds for repayment of obligations.

State Government and local self-government securities are also risk free. The greater the degree of credit risk inherent in securities, the higher should be their interest rate to attract venturesome investors who would demand premium on such securities to compensate for high financial risk.

Principle # c. Maturity:

Besides credit risk, investments are also subject to money rate risk. Money rate risk arises from change in market price consequent upon interest rate fluctuations.

If the market rate of interest tends to shoot up and the bondholders want to dispose off the bonds, the price of the bond will go down because the bonds carry the rate lesser than the prevailing rate of interest. Money rate risk is intimately related with maturity of securities. The shorter the maturity, the more stable the price and vice versa.

This is essentially because one of the factors influencing the market price of a bond is the future payments computed on an annual basis. Therefore, the longer the maturity the greater is the influence of future income payments that are reflected in the price of the bond.

If, for example, the market rate of interest moves from 3 to 4 per cent, the price of a 20-year, 3 percent bond would drop to Rs.86.32 but a 5-year, 3 percent bond would drop to only Rs.95.51. This is a sizable difference and it explains why short-term securities are preferred to long-term obligations.

It should be noted here that money rate risk arises only when securities are disposed off before their maturity period. Where a firm can meet its cash shortages by liquidating a portion of its investment, funds should be invested in securities of different maturity patterns.

Thus, the firm should stagger its investment portfolio in such a way that a certain amount of securities mature at regular intervals. If funds released as a result of the maturity of a particular bond are not needed, they can be reinvested in those securities that best fit into the firm’s investment portfolio.

This will help the firm to improve its earnings and make the cash resources available as and when needed.

Principle # d. Taxability:

Market yield of securities is also affected by tax factor. There are certain category of securities which are exempted from levy of Income Tax and Wealth Tax. For example, in India interest on treasury saving deposit certificates, Post Office cash differ certificates.

12-years national plan savings certificates and such other certificates issued by the Central Government are exempted from income tax.

Similarly, certain securities, viz., ten-year saving deposit certificates, fifteen-year annuity certificates, twelve-year national defence certificates, Post Office national savings certificates, 6/1/2 Gold Bonds 1978, 79 Gold Bonds, 1980 and National Defence Gold Bonds, 1980 are exempted from Wealth Tax.

In view of the differential tax treatment, yields of different securities differ. Tax-exempted securities are sold in the market at lower yield than other securities of the same maturity. Tax factor should, therefore, be considered while choosing for short-term investment.

The following securities fulfills the above four requirements and hence they should comprise near cash assets:

1. Treasury Bills.

2. Central Government Securities.

3. State Government Securities.

4. Port-Trust Securities.

5. Semi-Government Securities.

6. Securities of Reputed Companies.

After determining liquidity requirements of the company for transaction and precautionary purposes, the finance manager is left with the task of deciding about the allocation of funds between cash and near cash assets. This is again a formidable problem.

However, the magnitude of the problem can be minimised with the help of the EOQ approach. The EOQ approach suggests a minimum size of cash resources which a company should have all the time to meet its transaction requirements. Thus, any excess of cash should be invested in near cash assets to replenish primary reserves.

This approach is, however, useful only when cash flows are constant. Where cash flows are not steady and are of stochastic character, Miller and Orr stochastic models can be relied upon for allocation of liquid funds between the two. Thus, according to the model amount of cash lying between h and z points should be invested in near cash assets.

Skilful and prudent financial management of investment portfolios may be very much helpful in striking a satisfactory compromise between conflicting profitability and liquidity objectives while managing cash resources.

While investing funds in securities, a finance manager has to decide about the amount of funds to be invested and the type of securities in which to invest. Both these decisions are dependent upon evaluation of projected cash flows and certainty of these flows.

When the pattern of future cash flows is known with certainty the portfolio of securities should be so arranged as to satisfy the needs of cash when they arise. Thus, by projecting the dates when cash will be needed, securities whose maturity dates coincide with the dates of cash requirements, can be chosen.

This sort of planning will minimise the cost of converting securities into cash and vice versa. However, this will not be feasible when expected cash flows patterns are uncertain. In such situations, maturity diversification of the investment portfolio will be very desirable.

According to the maturity diversification, the maturities of securities investment should be so staggered that a certain amount of securities mature regularly and hence the cash will be available. If cash is not needed, cash available from the maturing debt may be reinvested. This will reduce the problem of converting securities into cash.

For proper management of securities, it is necessary for the company to have an investment department. Size of the department will depend upon many factors including size of the investment portfolio, type of securities purchased and held in the investment portfolio.

As in any other operation, degree of specialisation depends upon the magnitude of investment portfolio and the availability of resources. A company having a large security portfolio may employ a separate staff with people skilled in various phases of the investment activity and with funds for research and analysis.

These specialists have at their fingertips a wealth of materials in the form of service and financial and economic data that have bearing on the investment programme. With such an investment organisation, the company may build up an investment portfolio widely diversified in terms of securities, companies, industries, regions and maturities.

This will tend to minimise risks inherent in investment, maximise the return on investments and make cash regularly available to meet cash drains. A company with small investment portfolio may not afford a separate organisation. The investment function in such an organisation is performed by a single person.

Multiple Choice Questions and Answers

1. The cash management refers to management of

(a) Cash only

(b) Cash and bank balances

(c) Cash and near cash assets

(d) Fixed assets

Ans (b)

2. The new float of cash management is positive when

(a) The firms disbursement float is more than the collection float

(b) The firms collection float is more than the disbursement float

(c) Both (a) and (b)

(d) None of (a) and (b)

Ans (b)

3. Which of the following is not an object of cash management?

(a) Maximisation of cash balance

(b) Minimisation of cash balance

(c) Optimisation of cash balance

(d) Zero cash balance

Ans (c)

4. Marketable securities are primarily

(a) Equity shares

(b) Preference shares

(c) Fixed deposits with companies

(d) Short term debt investments

Ans (d)

5. Baumol’s model of cash management attempts to

(a) Minimise the holding cost

(b) Minimisation of transaction cost

(c) Minimisation of total cost

(d) Minimisation of cash balance

Ans (c)

6. Which of the following is not considered by Miller-Orr model?

(a) Variability in cash requirement

(b) Cost of transaction

(c) Floating cost

(d) Total annual requirement of cash

Ans (d)

7. Miller-Orr model deals with

(a) Optimal cash balance

(b) Optimum finished goods

(c) Optimum receivables

(d) All of the above

Ans (a)

8. Float management is related to

(a) Cash management

(b) Inventory management

(c) Receivables management

(d) Raw materials management

Ans (a)

9. The transaction motive for holding cash is for

(a) Safety cushion

(b) Daily operations

(c) Purchase of assets

(d) Payment of dividends

Ans (b)

10. _____ refers to a firm holding some cash to meet its routine expenses that are incurred in the ordinary course of business

(a) Speculative motive

(b) Transaction motive

(c) Precautionary motive

(d) Compensating motive

Ans (b)

11. Which of the following is not a motive of holding cash?

(a) Transaction motive

(b) Precaution motive

(c) Capital investment

(d) None of the above

Ans (c)

12. Which of the following motives for holding cash is required by the bank before loaning money?

(a) Precautionary motive

(b) Transaction motive

(c) Compensating balance motive

(d) None of the above

Ans (c)

13. Concentration banking helps in

(a) Reducing idle bank balance

(b) Increasing collection

(c) Increasing creditors

(d) Reducing bank transactions

Ans (b)

14. Financial managers use the_______ to plan for monthly financing needs

(a) Capital budget

(b) Pro forma income statement

(c) Cash budget

(d) None of the above

Ans (c)

15. Cash budget does not include

(a) Dividend payable

(b) Postal expenditure

(c) Issue of capital

(d) Total sales figure

Ans (d)

16. Which of the following is not shown in cash budget?

(a) Proposed issue of capital

(b) Loan repayment

(c) Interest on loan

(d) Depreciation

Ans (d)

17. Which of the following is not considered while preparing cash budget?

(a) Accrual principle

(b) Difference in capital and revenue items

(c) Conservation principle

(d) All of the above

Ans (d)

18. Which of the following is not true for cash budget?

(a) Shortage or excess of cash would appear in a particular period

(b) All inflows would arise before outflows for those periods

(c) Only revenue nature cash flows are shown

(d) Proposed issue of shares is shown as an inflow

Ans (c)

19. Which of the following is not true of cash budget?

(a) Cash budget indicates timing of short term borrowing

(b) Cash budget is based on accrual concept

(c) Cash budget is based on cash flow concept

(d) Repayment of principal amount is shown in cash budget

Ans (b)

20. Which of the following would be included in a cash estimation / budget?

(a) Depreciation

(b) Dividends

(c) Goodwill

(d) Patent amortization

Ans (b)

21. Cheque deposited in bank may not be available for immediate use due to

(a) Payment float

(b) Receipt float

(c) Net float

(d) Playing the float

Ans (b)

22. Difference between balance as per pass book and balance as per cash book may be due to

(a) Overdraft

(b) Float

(c) Factoring

(d) None of these

Ans (b)

23. Basic characteristics of short term marketable securities

(a) High return

(b) High risk

(c) High marketability

(d) High safety

Ans (c)

24. Which of the following is not a metric to use for measuring the length of cash cycle?

(a) Acid test days

(b) Accounts receivable days

(c) Accounts payable days

(d) Inventory days

Ans (a)

25._____ is the length of time between the firm’s actual cash expenditure and its own cash receipt

(a) Net operating cycle

(b) Cash conversion cycle

(c) Working capital cycle

(d) Gross operating cycle

Ans (a)

26. Firms aim to hold________ cash balances since cash is a non interest earning asset

(a) High

(b) Average

(c) Low

(d) None of the above

Ans (c)