Project

Financial Management

Name: Talha Sheraz(28)

Muhammad Usman(29)
Muhammad Ali(35)
Usama Iqbal(18)

Program: BBA - (6)

Teacher Name: Prof. Faisal
Abbas
Date of Submission: 18-July-2018
 BAUMOL MODEL OF CASH MANAGEMENT AND
MILLER ORR MODEL OF CASH MANAGEMENT

1. Baumol Model of Cash Management

Baumol model of cash management helps in determining a firm’s optimum cash balance under
certainty. It is extensively used and highly useful for the purpose of cash management. As per
the model, cash and inventory management problems are one and the same.
William J. Baumol developed a model (The transactions Demand for Cash: An Inventory
Theoretic Approach) which is usually used in Inventory management & cash management.
Baumol model of cash management trades off between opportunity cost or carrying cost or
holding cost & the transaction cost. As such firm attempts to minimize the sum of the holding
cash & the cost of converting marketable securities to cash.Relevance

At present many companies make an effort to reduce the costs incurred by owning cash. They
also strive to spend less money on changing marketable securities to cash. The Baumol model
of cash management is useful in this regard.

1. Use of Baumol Model

The Baumol model enables companies to find out their desirable level of cash balance under
certainty. The Baumol model of cash management theory relies on the trade off between the
liquidity provided by holding money (the ability to carry out transactions) and the interest
foregone by holding one’s assets in the form of non-interest bearing money. The key variables
of the demand for money are then the nominal interest rate, the level of real income which
corresponds to the amount of desired transactions and to a fixed cost of transferring one’s
wealth between liquid money and interest bearing assets.

2. Assumptions
There are certain assumptions or ideas that are critical with respect to the Baumol model of
cash management:The particular company should be able to change the securities that they own
into cash, keeping the cost of transaction the same. Under normal circumstances, all such deals
have variable costs and fixed costs.The company is capable of predicting its cash necessities.
They should be able to do this with a level of certainty. The company should also get a fixed
amount of money. They should be getting this money at regular intervals.
The company is aware of the opportunity cost required for holding cash. It should stay the same
for a considerable length of time.

The company should be making its cash payments at a consistent rate over a certain period of
time. In other words, the rate of cash outflow should be regular.

3. Equational Representations in Baumol Model of Cash

Management:
Holding Cost = k(C/2)

Transaction Cost = c(T/C)

Total Cost = k(C/2) + c(T/C)

Where T is the total fund requirement, C is the cash balance, k is the opportunity cost & c is
the cost per transaction.

4. Limitations of the Baumol model:

1.It does not allow cash flows to fluctuate.

2. Overdraft is not considered.

3. There are uncertainties in the pattern of future cash flows.

2. Miller and Orr Model of Cash Management

The Miller and Orr model of cash management is one of the various cash management models
in operation. It is an important cash management model as well. It helps the present day
companies to manage their cash while taking into consideration the fluctuations in daily cash
flow.
 Miller – orr model

Overview
The Miller and Orr model of cash management is one of the various cash management models in
operation. It is an important cash management model as well. It helps the present day companies to
manage their cash while taking into consideration the fluctuations in daily cash flow.

Description
As per the Miller and Orr model of cash management the companies let their cash balance move
within two limits
a) Upper Control limit
b) Lower Control Limit

Explanation For the Diagram

• Along with a return point when the cash balance touches the upper Control limit (h), the marketable
security is purchased to the extend till it reaches normal cash balance (Z)
• In the same manner when the cash balance touches lower limit (o), the firm Will Sell the Marketable
security to the extent till it reaches normal cash Balance (Z)
Benefits:
• Allows for net cash flow in a random fashion.
• Produce control limit can be used as basis for balance management.

Limitations
• May prove difficult to calculate.
• Monitoring needs to be calculated for the organizations benefits becomes a tedious Work.

Application
• Finding out the approximate prices at which the salable securities could be sold or bought
• Deciding the minimum possible levels of desired cash balance
• Checking the rate of interest
• Calculating the SD (Standard Deviation) of regular cash flows

Cash Budget
A cash budget is a budget or plan of expected cash receipts and disbursements during the
period. These cash inflows and outflows include revenues collected, expenses paid, and loans
receipts and payments. In other words, a cash budget is an estimated projection of the
company's cash position in the future.
Management usually develops the cash budget after the sales, purchases, and capital
expenditures budgets are already made. These budgets need to be made before the cash budget
in order to accurately estimate how cash will be affected during the period.

For example, management needs to know a sales estimate before it can predict how much cash
will be collected during the period. Management uses the cash budget to manage the cash flows
of a company. In other words, management must make sure the company has enough cash to
pay its bills when they come due.

Chartered Institute of Management Accountant (CIMA) defines cash budgets as a short-term

fiscal plan expressed in money which is prepared in advance. It helps to determine the cash-
inflow and cash-outflow of the business.

Features of Cash Budget

1. The cash-budget period is broken down into periods, mainly in months.
2. The cash-budget is always in columnar form i.e. column showing each month.
3. Payments and receipts of cash are identified in different heading and showing total for each
month.
4. The surplus of total cash payment over receipts or of receipts over payment for each month
is shown.
5. The running balances of cash, which would be determined by taken the balance at the end
of the previous month and adjusting it for either deficit or surplus of receipts over payments
for current month, is identified.

Importance of Cash Budget

Cash budget is an important tool in the hands of financial management for the planning and
control of the working capital to ensure the solvency of the firm. The importance of cash
budget may be summarised as follow:

1. Helpful in Planning: Cash budget helps planning for the most efficient use of cash. It points
out cash surplus or deficiency at selected point of time and enables the management to arrange
for the deficiency before time or to plan for investing the surplus money as profitable as
possible without any threat to the liquidity.

2. Forecasting the Future needs: Cash budget forecasts the future needs of funds, its time and
the amount well in advance. It, thus, helps planning for raising the funds through the most
profitable sources at reasonable terms and costs.

3. Maintenance of Ample cash Balance: Cash is the basis of liquidity of the enterprise. Cash
budget helps in maintaining the liquidity. It suggests adequate cash balance for expected
requirements and a fair margin for the contingencies.

4. Controlling Cash Expenditure: Cash budget acts as a controlling device. The expenses of
various departments in the firm can best be controlled so as not to exceed the budgeted limit.

5. Evaluation of Performance: Cash budget acts as a standard for evaluating the financial
performance.

6. Testing the Influence of proposed Expansion Programme: Cash budget forecasts the
inflows from a proposed expansion or investment programme and testify its impact on cash
position.

7. Sound Dividend Policy: Cash budget plans for cash dividend to shareholders, consistent
with the liquid position of the firm. It helps in following a sound consistent dividend policy.

8. Basis of Long-term Planning and Co-ordination: Cash budget helps in co-coordinating

the various finance functions, such as sales, credit, investment, working capital etc. it is an
important basis of long term financial planning and helpful in the study of long term financing
with respect to probable amount, timing, forms of security and methods of repayment.
Format and Example

The following example illustrates the format of cash budget. Company A maintains a minimum cash balance of $5,000. In
case of a deficiency, loan is obtained at 8% annual interest rate on the first day of the period.

Company A
Cash Budget
For the Year Ending December 30, 2010

Quarter
1 2 3 4 Year
Beginning Cash Balance $5,200 $5,000 $5,000 $11,740 $5,200
Add: Budgeted Cash Receipts: 37,150 54,190 53,730 62,300 207,370
Total Cash Available for Use $42,350 $59,190 $58,730 $74,040 $212,570
Less: Cash Disbursements
Direct Material 14,960 16,550 16,810 19,410 67,730
Direct Labor 8,830 9,610 9,750 11,900 40,090
Factory Overhead 10,020 10,400 11,000 11,780 43,200
Selling and Admin. Expenses 7,640 8,360 8,500 9,610 34,110
Equipment Purchases 6,000 14,000 20,000
Total Disbursements $41,450 $50,920 $46,060 $66,700 $205,130
Cash Surplus/(Deficit) $900 $8,270 $12,670 $7,340 $7,440
Financing:
Borrowing 4,100 4,000
Repayments −3,188 −912 −4,000
Interest −82 −18 −100
Net Cash from Financing $4,100 −$3,270 −$930 −100
Budgeted Ending Cash Balance $5,000 $5,000 $11,740 $7,340 $7,340

Cash conversion cycle

Central to a firm’s working capital management is an understanding of its cash conversion
cycle, or how long it takes for the company to convert cash invested in operations into cash
received. The cash conversion cycle measures the time passed from the beginning of the
production process to collection of cash from the sale of the finished product. Typically a
firm buys raw materials and produces a product.
This product goes into inventory and then is sold. Once the product is sold then the firm waits
to recieve payment, at which point the process begins again. How long does this take?
Understanding this cycle is essential to successful working capital management.
Calculating the Cash Conversion Cycle
The cash conversion cycle is divided into three parts: the average payment period, the
average collection period and the average age of inventory. The firm’s operating cycle is
length of time from the receipt of raw materials to the collection of payment for the goods
sold. This is, essentially, how long it takes from
the start of making a new product until we receive cash (on average). The operating cycle is
thus the sum of the inventory conversion period (the average time between when raw
materials are received into inventory and product is sold) and the receivables conversion
period (the average time between a sale and collection of the receipt).

The inventory conversion period can be estimated if we know the average balance of our
inventory and the average value of goods sold each day of the year. The latter should be equal
to cost of goods sold for the year divided by 365.
Equation 17.1 Inventory Conversion Period

InventoryConversionPeriod = Avg. Inventory/Avg. DailyCostofGoodsSold

As an example, if we have $60 thousand in inventory and sell $3 thousand worth of goods
every day, then our inventory takes, on average, $60 thousand/$3 thousand per day = 20 days
to sell. This, of course, includes production time as well as time that inventory “sits on the
shelves”. Likewise, the receivables conversion period can be estimated if we know the
average balance of our account receivables and the average revenues each day of the year.
The latter should be equal to revenues for the year divided by 365.

Equation 17.2 Receivables Conversion Period

ReceivablesConversionPeriod = Avg. Receivables/ A/R

Avg. DailyRevenues (Revenues/365)
As an example, if we have $12 thousand in receivables and sell $4 thousand in
revenues per day, then our receivables take, on average, $120 thousand/$4 thousand per day
= 30 days to collect.
Equation 17.3 Operating Cycle

OperatingCycle = InventoryConversionPeriod + ReceivablesConversion

In our examples, the operating cycle is 20 days + 30 days = 50 days. When we purchase raw
materials, however, we don’t typically pay for them immediately. Just as we offer customers
credit, our suppliers will usually provide opportunities for credit to us. Therefore, our cash is
not tied up for the entire
operating cycle, but just the time from when we finally have to pay for raw materials. This
length of time or payables conversion period9 (the average time between acquiring raw
materials and payment for them) is subtracted from the operating cycle to determine the
entire cash conversion cycle. Unfortunately, total purchases are not readily available from the
income statement, so we will often have to estimate them as a percentage of cost of goods
sold.
Equation 17.4 Payables Conversion Period

PayablesConversionPeriod = Avg. Payables/ A/P

Avg. DailyPurchases (Purchases/365)

As an example, if we have $30 thousand in payables and purchase $2 thousand in

raw materials per day, then our payables take, on average, $30 thousand/$2
thousand per day = 15 days

Equation 17.5 Cash Conversion Cycle

CashConversionCycle = OperatingCycle – Payable Inventory Conversion Period +

Receivables Cash Inventory

Our examples cash conversion cycle is thus 20 days + 30 days - 15 days = 35 days.

Typically, the shorter the cash conversion cycle, the better, as it means we are keeping our
cash moving instead of having it tied up in Net Working Capital. There are other
considerations, however. Perhaps, extending collections of receivables, for example, might
entice more sales from our customers. Then we need to balance the benefits from the extra
sales with the additional costs in Net Working Capital
due to the lengthening cash conversion cycle.

How Do We Manage the Cash Conversion Cycle?

When a firm changes any of these variables, then their cash conversion cycle changes.
Certain steps can be taken to reduce a firm’s cash conversion cycle. These steps include:
1. Reduce the average age of inventory. Improve their inventory conversion period by
making goods and selling them faster through more efficient processes. Avoiding inventory
shortages or stockouts helps too.
2. Reduce the average collection period. Speed up collections on accounts receivable. Collect
A/R as quickly as possible without losing customers but maintain good credit relations with
customers.
3. Increase the payables deferral period. Pay A/P as slowly as possible without harming credit
rating or relationship with supplier.