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INTRODUCTION:
The term ‘cash’ with reference to cash management is used in two senses.
In a narrow sense, it is used broadly to cover currency and generally
accepted equivalents of cash, such as cheques, drafts and demand deposits
in banks. The broad view of cash also includes near-cash assets, such as
marketable securities and time deposits in banks. The main characteristics of
these are that they can be readily sold and converted into cash. They serve
as a reserve pool of liquidity that provides cash quickly when needed. They
also provide a short term investment outlet for excess cash and are also
useful for meeting planned outflow of funds. Here, the term cash
management is employed in broader sense. Irrespective of the form in which
it is held, a distinguishing feature of cash, as an asset, is that it has no
earning power. There are four primary motives for maintaining cash
balances –
1) Transaction motive
2) Precautionary motive
3) Speculative motive
4) Compensating motive
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1) Transaction motive:
Of the receipts of cash and its disbursements could exactly coincide in the
normal course of operations, a firm would not need cash for transaction
purposes. Although a major part of transaction balances are held in cash,
a part may also be in such marketable securities whose maturity
conforms to the timing of the anticipated payments, such as payment of
taxes, dividends and so on.
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2) Precautionary motive:
The cash balances held in reserve for such random and unforeseen
fluctuations in cash flows are called as precautionary balances. In other
words, precautionary motive of holding cash implies the need to hold
cash to meet unpredictable contingencies. Thus, precautionary cash
balance serves to provide a cushion to meet unexpected contingencies.
The more unpredictable are the cash flows, the larger is the need for such
balances.
Another factor which has a bearing on the level of such cash balances is
the availability of short-term credit. If a firm can borrow at short notice to
pay for unforeseen obligations, it will need to maintain a relatively small
balance and vice versa.
Such cash balances are usually held in the form of marketable securities
so that they earn a return.
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3) Speculative motive:
4) Compensating motive:
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use the amount to earn a return. Such balances are compensating
balances.
Of the four motives of holding cash balances, the two most important are
the transactions motive and the compensation motive. Business firms
normally do not speculate and need not have speculative balances. The
requirement of precautionary balances can be met out of short-term
borrowings.
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OBJECTIVES OF CASH MANAGEMENT
The basic objectives of cash management are two-fold :–
These are conflicting and mutually contradictory and the task of cash
management is to reconcile them.
The importance of sufficient cash to meet the payment schedule can hardly
be overemphasized. The advantages of adequate cash are:
iii) It helps in fostering good relations with trade creditors and suppliers of
raw materials, as prompt payment may help their own cash management
iv) A cash discount can be availed of if payment is made within due date
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v) It leads to a strong credit rating which enables the firm to purchase goods
on favourable terms and to maintain its line of credit with banks and
other sources of credit
vii) The firm can meet unanticipated cash expenditure with a minimum of
strain during emergencies, such as strikes, fires or a new marketing
campaign by competitors
Keeping large cash balances, however, implies a high cost. The advantage of
prompt payment of cash can well be realized by sufficient and not excessive
cash.
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FACTORS DETERMINING CASH NEEDS
The factors that determine the required cash balances are:
The need for maintaining cash balances arises from the non-synchronization
of the inflows and outflows of cash: if the receipts and payments of cash
perfectly coincide or balance each other, there would be no need for cash
balances. The first consideration in determining the cash need is, therefore,
the extent of non- synchronization of cash receipts and disbursements. For
this purpose, the inflows and outflows have to be forecast over a period of
time, depending upon the planning horizon which is typically a one-year
period with each of the 12 months being a sub period. The technique
adopted is a cash budget. A properly prepared budget will pinpoint the
months/periods when the firm will have an excess or a shortage of cash.
Short Costs
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covered. Expenses incurred as a result of shortfall are called short costs.
Included in the short costs are the following:
The cost of having excessively large cash balances is known as the excess
cash balance cost. If large funds are idle, the implication is that the firm has
missed opportunities to invest those funds and have thereby lost interest
which it would otherwise have earned. This loss of interest is primarily the
excess cost.
These are the costs associated with establishing and operating cash
management staff and activities. They are generally fixed and are mainly
accounted for by salary, storage, handling of securities, and so on.
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Uncertainty and Cash Management
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DETERMINING CASH NEED
After the examination of the pertinent considerations and cost that
determine cash needs, the next aspect relates to the determination of cash
needs.
There are two approaches to derive an optimal cash balance, namely (a)
minimizing cost cash models and (b) cash budget
While it is true that financial managers need not necessarily follow cash
management models exactly but a familiarity with them provides an insight
into the normative framework as to how cash management should be
conducted. One the important analytical model for cash management is the
Baumol Model.
Baumol Model
The Baumol model enables companies to find out their desirable level of
cash balance under certainty.
Relevance
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Assumptions
There are certain assumptions or ideas that are critical with respect to the
Baumol model of cash management:
Illustration
The ABC Ltd requires Rs. 30 lakhs in cash to meet its transaction needs
during the next three month cash planning period. It holds marketable
securities of an equal amount. The annual yield on these marketable
securities is 20%. The conversion of these securities into cash entails a fixed
cost of cash per order. Assuming ABC Ltd can sell its marketable securities in
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any of the five lot size: Rs 1,50,000; Rs 3,00,000; Rs 6,00,000; Rs
7,50,000; Rs 15,00,000; prepare a table indicating the economic lot size
using numerical analysis.
Solution:
C = 2bT
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CASH BUDGET
A firm is well advised to hold adequate cash balances but should avoid
excessive balances. The firm has, therefore, to assess its need for cash
properly. The cash budget is probably the most important toll in cash
management. It is a device to help a firm to plan and control the use of
cash. It is a statement showing the estimated cash inflows and cash outflows
over the planning horizon. In other words, the net cash position (surplus or
deficiency) of a firm as it moves from one budgeting subperiod to another is
highlighted by the cash budget.
The various purpose of cash budgets are: (i) to coordinate the timings of
cash needs. It identifies the periods when there might be a shortage of cash
or an abnormally large cash requirement; (ii) it pinpoints the period when
there is likely to be excess cash; (iii) it enables a firm which has sufficient
cash to take advantage of cash discounts on its accounts payable , to pay
obligations when due , to formulate dividend policy, to plan financing of
capital expansion and to help unify the production schedule during the year
so that the firm can smooth out costly seasonal fluctuations , finally, (iv) it
helps to arrange needed funds on the most favourable terms and prevents
the accumulation of excess funds. With adequate time to study his needs,
the finance manager can select the best alternative. In contrast, a firm
which does not budget its cash requirements, may suddenly find itself short
of funds. With pressing needs and little time to explore alternative avenues
of financing, the management would be forced to accept the best terms
offered in a difficult situation. These terms will not be as favourable, since
the lack of planning indicates to the lender, the is no organizational
deficiency. The firm, therefore, represents a higher risk.
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Elements/Preparation of Cash Budget
Thus, the principal aim of the cash budget, as a tool to predict cash flows
over a given period of time, is to ascertain whether at any point of time
there is likely to be an excess or shortage of cash. The preparation of a cash
budget involves various steps.
The first element of a cash budget is the selection of the period of time
to be covered by the budget. It is referred to as the planning horizon. The
planning horizon means the time span and the sub periods within that time
span over which the cash flows are to be projected. There is no fixed rule.
The coverage of a cash budget will differ from firm to firm depending upon
its nature and the degree of accuracy with which the estimates can be made.
As a general rule , the period selected should be neither too long too short.
If it is too long, it is likely that the estimates will just beyond the period
cannot be accounted for and the work associated with the preparation of the
budget becomes excessive.
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provide information on the fluctuation in the cash reservoir level during the
time span covered by the budget.
The second element of the cash budget is the selection of the factors
that have a bearing on cash flows. The items included in the cash budget are
only cash items; non-cash items such as depreciation and amortization are
excluded. The factors that generate cash flows are generally divided, for
purposes of the construction of cash budget, into two broad categories; (a)
operating, and (b) financial. These two–fold classifications of cash budget
items are based on their nature. While the former category includes cash
flows generated by the operations of the firms and are known as operating
cash flows, the latter consists of financial cash flows.
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