CASH MANAGEMENT
Introduction To Cash Management
Cash management is one of the key areas of working capital management. Apart from the fact that it is the most liquid current asset, cash is the common denominator to which all current assets can be reduced because the other major liquid assets, that is, receivables and inventory get eventually converted into cash. This underlines the significance of cash management. Cash management is a broad term that refers to the collection, concentration, and disbursement of cash. It encompasses a company'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 business managers.
If at any time a company fails to pay an obligation when it is due because of the lack of cash, the company is insolvent. Insolvency is the primary reason firms go bankrupt. Obviously, the prospect of such a dire consequence should compel companies 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. In United States banking, cash management, or treasury management, is a marketing term for certain services offered primarily to larger business customers. It may be used to describe all bank accounts (such as checking accounts) provided to businesses of a certain size, but it
1
CASH MANAGEMENT
is more often used to describe specific services such as cash concentration, zero balance accounting, etc. Sometimes, private banking customers are given cash management services.
Definitions
Definition 1:
“The strategy by which a company administers and invests its cash.”
Definition2:
“ The control of cash collections. ”
Objectives Of Cash Management :
Cash management is particularly important for new and growing businesses. Planning, monitoring, tracking, and managing your cash flow and cash balance is always important. In an economic downturn this becomes, perhaps, your most important business management activity. 1. To make Payment According to Payment Schedule:The basic objectives of cash management are two fold:
2
CASH MANAGEMENT
1. To meet the cash disbursement needs (payment schedule) and 2. To minimize funds committed to cash balances. These are conflicting and mutually contradictory and the task of management is to reconcile them. 2. Meeting payment schedule: In the normal course of business the firms have to make payments of cash on a continuous and regular basis to suppliers of goods, employees and so on. At the same time, there is a constant inflow of cash from debtors cash is therefore aptly described as the “oil to lubricate the ever turning wheels of business: without it the process grinds to a stop. A basic objective of cash to meet the payment schedule that is to have sufficient cash disbursement needs of a firm. Firm needs cash to meet its routine expenses including wages, salary, taxes etc. Following are main
advantages of adequate cash:
1. 2. 3. 4. 5. To prevent firm from being insolvent. The relation of firm with bank does not deteriorate. Contingencies can be met easily. It helps firm to maintain good relation?s with suppliers. A cash discount can be availed of if the payment is made within the due date. 6. It leads to a strong credit rating which enables the firm to purchase goods on favorable terms and to maintain its line of credit with banks and other sources of credit. 7. To take advantage of favorable business opportunities that may be available periodically and finally. 8. The firm can meet unanticipated cash expenditure during emergencies such as strikes, fires or new marketing campaigns by competitors. 3. To minimize Cash Balance:The second objective of cash management is to minimize cash balance. Excessive amount of cash balance helps in quicker payments, but excessive cash may remain unused & reduces profitability of business. Contrarily, when cash available with firm is less, firm is unable to pay its liabilities in time. Therefore optimum level of cash should be maintained. The key to successful cash management, therefore, lies in tabulating realistic projections, monitoring collections and disbursements, establishing effective billing and collection measures, and adhering to budgetary restrictions.
3
CASH MANAGEMENT
Effective Cash Management
Efficient cash management processes are pre-requisites to execute payments, collect receivables and manage liquidity. Managing the channels of collections, payments and accounting information efficiently becomes imperative with growth in business transaction volumes. This includes enabling greater connectivity to internal corporate systems, expanding the scope of cash management services to include “full-cycle” processes (i.e., from purchase order to reconciliation) via ecommerce, or cash management services targeted at the needs of specific customer segments. Cost optimization and value-add services are customer demands that necessitate the creation of a mechanism to service the various customergroups. Banks are increasingly becoming innovative and anticipating the needs of corporate towards standardization, ERP integration, reconciliation, real-time reporting, providing an end-to-end view of cash management value chain besides offering the ability to reach and be reached by their own customers. The mounting pressure from competitors forces the Banks to look for an Information Technology vendor who can offer better solutions and services in Cash Management and Internet Banking.
Factors Determining Cash Needs
The factors that determine the required cash balances are: 1. Synchronization of cash flows 2. Short costs 3. Excess cash balance
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CASH MANAGEMENT
4. Procurement and management, and 5. Uncertainty 1. Synchronization of cash flows The need for maintaining cash balances arises from the nonsynchronization 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. 2. Short costs Another general factor to be considered in determining cash needs is the cost associated with a shortfall in the cash needs. The cash forecast presented in the cash budget would reveal periods of cash shortages. In addition, there may be some unexpected shortfall. Every shortage of cash-whether expected or unexpected-involves a cost „depending upon the severity, duration and frequency of the shortfall and how the shortage is covered. Expenses incurred as a result of shortfall are called short costs. Included in the shorts costs are the following:
(i)
(ii)
(iii)
Transaction costs associated with raising cash to tide over the shortage. This is usually the brokerage incurred in relation to the sale of some short-term near-cash assets such as marketable securities. Borrowing costs associated with borrowing to cover the shortage. These include items such as interest on loan, commitment charges and other expenses relating to the loan. Loss of cash-discount, that is, a substantial loss because of a temporary shortage of cash.
5
CASH MANAGEMENT (iv)
Cost associated with deterioration of the credit rating which is reflected in higher bank charges on loans, stoppage of supplies, demands for cash payment, refusal to sell, loss of image and the attendant decline in sales and profits. Penalty rates by banks to meet a shortfall in compensating balances.
(v)
3.
Excess cash balance costs 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 has thereby lost interest which it would otherwise have earned. This loss of interest is primarily the excess cost.
4.
Procurement and management These are the costs associated with establishing and operating cash management staff and activities. They are generally fixed and are mainly accounted by salary, storage, handling of securities, and so on.
5.
Uncertainty and cash management Finally, the impact of uncertainty on cash management strategy is also relevant as cash flows cannot be predicted with complete accuracy. The first requirement is a precautionary cushion to cope with irregularities? in cash flows, the unexpected delays in collections and disbursements, defaults and unexpected cash needs.
The impact of uncertainty on cash management can, however, be mitigated through
(i)
Improved forecasting of tax payments, capital expenditure, dividends, and so on; and
6
CASH MANAGEMENT (ii)
Increased ability to borrow through overdraft facility.
Motives For Holding Cash
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, draft 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 required. There are four primary motives for maintaining cash balances: 1) 2) 3) 4)
TRANSACTION MOTIVE PRECAUTIONARY MOTIVE SPECULATIVE MOTIVE COMPENSATING MOTIVE
1) TRANSACTION MOTIVE
An important reason for maintaining cash balances is the transaction motive. This refers to the holding of cash to meet routine cash requirements to finance the transactions which a firm carries on in the ordinary course of business. A firm enters into a variety of transactions to accomplish its objectives which have to be paid for in the form of cash. For example, cash payments have to be made for purchases, wages, operating expenses, financial charges like interest, taxes, dividends, and so on. Similarly there is a regular inflow of cash to the firm from sales operations, returns on outside investments?, and so on. These receipts and payments constitute a continuous two-way flow of cash. But the inflows (receipts) and outflows do not perfectly coincide or synchronize. At times, receipts exceed outflows while, at other times, payments exceed inflows. To ensure that the firm can meet its obligations when payments become due in a situation in which disbursement are in excess of the current receipts, it must have an adequate cash balances. The requirement of cash balances to meet routine cash needs is known as the transaction motive and such motive refers to the holding of
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CASH MANAGEMENT
cash to meet anticipated obligations whose timing is not perfectly synchronized with cash receipts. 2) PRECAUTIONARY MOTIVE In addition to the non-synchronization of anticipated cash inflows and outflows in an ordinary course of business, a firm may have to pay cash for purposes which cannot be predicted or anticipated. The unexpected cash needs at short notice may be the result of: ? ? ? ? Floods, strikes and failure of important customers; Bills may be presented for settlement earlier than expected Cancellation of some order for goods as the customer is not satisfied; Sharp increase in the cost of raw material.
The cash balances held in reserve for random and unforeseen fluctuations in cash flows are called as precautionary balances. In other words, 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. 3) SPECULATIVE MOTIVE It refers to the desire of a firm to take advantage of opportunities which present themselves at unexpected moments and which are typically outside the normal course of business. While precautionary motive is defensive in nature in that firms must make provisions to tide over unexpected contingencies, the speculative motive represents a positive and aggressive approach. Firms aim to exploit profitable opportunities and keep cash in reserve to do so. The speculative motive helps to take advantage of: ? An opportunity to purchase raw materials at a reduced price on payment of immediate price; ? A chance to speculate on interest rate movements by buying securities when interest rates are expected to decline; ? Delay purchases of raw materials on the anticipation of decline in prices; ? Make purchase at favorable price.
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CASH MANAGEMENT
4) COMPENSATING MOTIVE Yet another motive to hold cash balances is to compensate banks for providing certain services and loans. Banks provide a variety of services to business firms, such as clearance of cheque, supply of credit information, transfer of funds, and so on. While for some of these services banks charge a commission or fee, for others they seek indirect compensation. Usually clients are required to maintain a minimum balance of cash at a bank. Since these balances cannot be utilized by the firms for transaction purposes, the banks themselves can use the amount to earn return. Such balances are called as compensation balances. Of the four primary motives for maintaining cash balances, the two most important are transactions motive and the compensating 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.
Cash Budget : A Management Tool
A firm is well advised to hold adequate cash balances but should avoid excessive balances. The firm has, therefore, to assess its needs for cash properly. The cash budget is probably the most important tool 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 sub period to another is highlighted by the cash budget. The various purposes of cash budgets are: 1. To coordinate the timings of cash needs. It identifies the period when there might either be a shortage of cash or an abnormally large cash requirement. 2. It pinpoints the period when there is likely to be excess cash. 3. 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. 4. It helps to arrange needed funds on the most favorable 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.
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CASH MANAGEMENT
Elements/Preparation of Cash Budget:
The principle aim of 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 cash budget involves various steps. These may be described as the elements of the cash budgeting system. The first element of a cash budget is the selection of the period time to be covered by the budget. It is referred 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 nor too short. If it is too long, it is likely that the estimates will be inaccurate. If, on the other hand, the time span is too small, many important events which lie just beyond the period cannot be accounted for and the work associated with the preparation of the budget becomes excessive. The planning horizon of a cash budget should be determined in the light of the circumstances and requirements of a particular case. For instance, if the flows are expected to be stable and dependable, such a firm may prepare a cash budget covering a long period, say, a year and divide it into quarterly intervals. In the case of a firm whose flows are uncertain, a quarterly budget, divided into monthly intervals, may be appropriate. Where flows are affected by seasonal variations, monthly budgets, subdivided on a weekly or even a daily basis, may be necessary. If the flows are subject to extreme fluctuation, even a daily budget may be called for. The idea behind subdividing the budgeting period into smaller intervals is to highlight the movement of cash from one sub period to another. The subdivision will provide information on the fluctuations 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 purpose of the construction of cash budget, into two broad categories: (a) Operating, and (b) Financial. This two fold classification of cash budget items is based on their nature. While the former category includes cash flows generated by the operations of the
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CASH MANAGEMENT
firms and are known as operating cash flows, the latter consists of financial cash flows.
Cash management: basic strategies
The cash budget, as a cash management tool, helps the management to know the net cash position of a firm so that the management can work out the basic strategies to be employed to manage its cash. The broad cash management strategies are essentially related to the cash turnover process, that is, the cash cycle together with the cash turnover. The CASH CYCLE refers to the process by which cash is used to purchase materials from which are produced goods, which are then sold to the customers, who later pay the bills. The firm receives cash from customers and the cycle repeats itself. The CASH TURNOVER means the number of time the cash is used during each year. MINIMUM OPERATING CASH The higher the cash turnover, the less is the cash a firm requires. A firm should, therefore, try to maximize the cash turnover. But it must maintain a minimum amount of operating cash balance so that it does not run out of cash. The firm should maintain a minimum level of operating cash so that it would not have to borrow anything. But minimum operating cash involves a cost in terms of the earnings foregone from investing in temporarily, that is to say, there is an opportunity cost. The minimum level of operating cash is determined by dividing the total annual outlays by the cash turnover rate. Cash management strategies are intended to minimize the operating cash balance requirement. The basic strategies that can be employed to do the needful are as follows: (a) (b) (c) (d) Stretching accounts payable. Efficient inventory production management. Speedy collection of accounts receivable, and Combined cash management strategies. In other words, efficient cash management implies minimum cash balance consistent with the need to pay bills when they become due.
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CASH MANAGEMENT
(a) Stretching Accounts Payable. A firm should pay its accounts payable as late as possible without damaging its credit standing. It should, however, take advantage of the cash discount available on prompt payment. (b) Efficient Inventory Production Management Another strategy is to increase the inventory turnover, avoiding stockouts, that is, shortage of stocks. This can be done in the following ways: 1. Increasing the raw material turnover by using more efficient inventory control techniques. 2. Decreasing the production cycle through better production planning, scheduling and control techniques. It will lead to an increase in the work-inprogress inventory turnover. 3. Increasing the finished goods turnover through better forecasting of demand and a better planning of production. (c) Speedy Collection of Accounts Receivable Yet another strategy of cash management is to collect accounts receivable as early as possible without losing future sales because of high-pressure of collection techniques. The average collection period of receivable reduced by changes in: (i) (ii) (iii) Credit terms. Credit standards, and Credit policies.
In brief, CREDIT STANDARDS represents the criteria for determining to whom credit should be extended. The COLLECTION POLICIES determines the effort put forth to collect the accounts receivable promptly. (d) Combined Cash Management Strategies.
The three basic cash management strategies, related to 1. 2. Accounts payable Inventory and
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CASH MANAGEMENT
3. Accounts receivable, lead to a reduction in the cash balances. But, they simply problems for the management. They are as follows: 1. If the accounts payable are postponed too long, the credit standing of the firm may be adversely affected. 2. A low level of inventory may lead to a stoppage of production as sufficient raw materials may not be available for uninterrupted production, or the firm may be short of enough stock to meet the demand for its product, that is, stock-out. 3. Restrictive credit standards, credits terms and collection policies may jeopardize sales. These implications should be constantly kept in view while working out cash management strategies.
Cash Management in Troubled Times
Many small business experience cash flow difficulties, especially during their first years of operation. But entrepreneurs and managers can take steps to minimize the impact of such problems and help maintain the continued viability of the business. Suggested steps to address temporary cash flow problems include:
1. Create a realistic cash flow budget that charts finances for both the short 2.
term (30-60 days) and longer term (1-2 years). Redouble efforts to collect on outstanding payments owed to the company. "Bill promptly and accurately," counseled the Journal of Accountancy. "The faster you mail an invoice, the faster you will be paid…If deliveries do not automatically trigger an invoice, establish a set billing schedule, preferably weekly." Businesses should also include a payment due date. Offer small discounts for prompt payment. Consider compromising on some billing disputes with clients. Small business owners are understandably reluctant to consider this step, but in certain cases, obtaining some cash—even if your company is not at fault in the dispute—for products sold/services rendered may be required to pay basic expenses. Closely monitor and prioritize all cash disbursements. Contact creditors (vendors, lenders, and landlords) and attempt to negotiate mutually satisfactory arrangements that will enable the business to weather its cash shortage (provided it is a temporary one). In some cases, you may be
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3. 4.
5. 6.
CASH MANAGEMENT
able to arrange better payment terms from suppliers or banks. "Better credit terms translate into borrowing money interest-free," states the Journal of Accountancy. 7. Liquidate superfluous inventory. 8. Assess other areas where operational expenses may be cut without permanently disabling the business, such as payroll or goods/services with small profit margins. "Every operation struggling for survival is losing money in some of its components,"
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doc_626148697.docx
Introduction To Cash Management
Cash management is one of the key areas of working capital management. Apart from the fact that it is the most liquid current asset, cash is the common denominator to which all current assets can be reduced because the other major liquid assets, that is, receivables and inventory get eventually converted into cash. This underlines the significance of cash management. Cash management is a broad term that refers to the collection, concentration, and disbursement of cash. It encompasses a company'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 business managers.
If at any time a company fails to pay an obligation when it is due because of the lack of cash, the company is insolvent. Insolvency is the primary reason firms go bankrupt. Obviously, the prospect of such a dire consequence should compel companies 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. In United States banking, cash management, or treasury management, is a marketing term for certain services offered primarily to larger business customers. It may be used to describe all bank accounts (such as checking accounts) provided to businesses of a certain size, but it
1
CASH MANAGEMENT
is more often used to describe specific services such as cash concentration, zero balance accounting, etc. Sometimes, private banking customers are given cash management services.
Definitions
Definition 1:
“The strategy by which a company administers and invests its cash.”
Definition2:
“ The control of cash collections. ”
Objectives Of Cash Management :
Cash management is particularly important for new and growing businesses. Planning, monitoring, tracking, and managing your cash flow and cash balance is always important. In an economic downturn this becomes, perhaps, your most important business management activity. 1. To make Payment According to Payment Schedule:The basic objectives of cash management are two fold:
2
CASH MANAGEMENT
1. To meet the cash disbursement needs (payment schedule) and 2. To minimize funds committed to cash balances. These are conflicting and mutually contradictory and the task of management is to reconcile them. 2. Meeting payment schedule: In the normal course of business the firms have to make payments of cash on a continuous and regular basis to suppliers of goods, employees and so on. At the same time, there is a constant inflow of cash from debtors cash is therefore aptly described as the “oil to lubricate the ever turning wheels of business: without it the process grinds to a stop. A basic objective of cash to meet the payment schedule that is to have sufficient cash disbursement needs of a firm. Firm needs cash to meet its routine expenses including wages, salary, taxes etc. Following are main
advantages of adequate cash:
1. 2. 3. 4. 5. To prevent firm from being insolvent. The relation of firm with bank does not deteriorate. Contingencies can be met easily. It helps firm to maintain good relation?s with suppliers. A cash discount can be availed of if the payment is made within the due date. 6. It leads to a strong credit rating which enables the firm to purchase goods on favorable terms and to maintain its line of credit with banks and other sources of credit. 7. To take advantage of favorable business opportunities that may be available periodically and finally. 8. The firm can meet unanticipated cash expenditure during emergencies such as strikes, fires or new marketing campaigns by competitors. 3. To minimize Cash Balance:The second objective of cash management is to minimize cash balance. Excessive amount of cash balance helps in quicker payments, but excessive cash may remain unused & reduces profitability of business. Contrarily, when cash available with firm is less, firm is unable to pay its liabilities in time. Therefore optimum level of cash should be maintained. The key to successful cash management, therefore, lies in tabulating realistic projections, monitoring collections and disbursements, establishing effective billing and collection measures, and adhering to budgetary restrictions.
3
CASH MANAGEMENT
Effective Cash Management
Efficient cash management processes are pre-requisites to execute payments, collect receivables and manage liquidity. Managing the channels of collections, payments and accounting information efficiently becomes imperative with growth in business transaction volumes. This includes enabling greater connectivity to internal corporate systems, expanding the scope of cash management services to include “full-cycle” processes (i.e., from purchase order to reconciliation) via ecommerce, or cash management services targeted at the needs of specific customer segments. Cost optimization and value-add services are customer demands that necessitate the creation of a mechanism to service the various customergroups. Banks are increasingly becoming innovative and anticipating the needs of corporate towards standardization, ERP integration, reconciliation, real-time reporting, providing an end-to-end view of cash management value chain besides offering the ability to reach and be reached by their own customers. The mounting pressure from competitors forces the Banks to look for an Information Technology vendor who can offer better solutions and services in Cash Management and Internet Banking.
Factors Determining Cash Needs
The factors that determine the required cash balances are: 1. Synchronization of cash flows 2. Short costs 3. Excess cash balance
4
CASH MANAGEMENT
4. Procurement and management, and 5. Uncertainty 1. Synchronization of cash flows The need for maintaining cash balances arises from the nonsynchronization 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. 2. Short costs Another general factor to be considered in determining cash needs is the cost associated with a shortfall in the cash needs. The cash forecast presented in the cash budget would reveal periods of cash shortages. In addition, there may be some unexpected shortfall. Every shortage of cash-whether expected or unexpected-involves a cost „depending upon the severity, duration and frequency of the shortfall and how the shortage is covered. Expenses incurred as a result of shortfall are called short costs. Included in the shorts costs are the following:
(i)
(ii)
(iii)
Transaction costs associated with raising cash to tide over the shortage. This is usually the brokerage incurred in relation to the sale of some short-term near-cash assets such as marketable securities. Borrowing costs associated with borrowing to cover the shortage. These include items such as interest on loan, commitment charges and other expenses relating to the loan. Loss of cash-discount, that is, a substantial loss because of a temporary shortage of cash.
5
CASH MANAGEMENT (iv)
Cost associated with deterioration of the credit rating which is reflected in higher bank charges on loans, stoppage of supplies, demands for cash payment, refusal to sell, loss of image and the attendant decline in sales and profits. Penalty rates by banks to meet a shortfall in compensating balances.
(v)
3.
Excess cash balance costs 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 has thereby lost interest which it would otherwise have earned. This loss of interest is primarily the excess cost.
4.
Procurement and management These are the costs associated with establishing and operating cash management staff and activities. They are generally fixed and are mainly accounted by salary, storage, handling of securities, and so on.
5.
Uncertainty and cash management Finally, the impact of uncertainty on cash management strategy is also relevant as cash flows cannot be predicted with complete accuracy. The first requirement is a precautionary cushion to cope with irregularities? in cash flows, the unexpected delays in collections and disbursements, defaults and unexpected cash needs.
The impact of uncertainty on cash management can, however, be mitigated through
(i)
Improved forecasting of tax payments, capital expenditure, dividends, and so on; and
6
CASH MANAGEMENT (ii)
Increased ability to borrow through overdraft facility.
Motives For Holding Cash
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, draft 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 required. There are four primary motives for maintaining cash balances: 1) 2) 3) 4)
TRANSACTION MOTIVE PRECAUTIONARY MOTIVE SPECULATIVE MOTIVE COMPENSATING MOTIVE
1) TRANSACTION MOTIVE
An important reason for maintaining cash balances is the transaction motive. This refers to the holding of cash to meet routine cash requirements to finance the transactions which a firm carries on in the ordinary course of business. A firm enters into a variety of transactions to accomplish its objectives which have to be paid for in the form of cash. For example, cash payments have to be made for purchases, wages, operating expenses, financial charges like interest, taxes, dividends, and so on. Similarly there is a regular inflow of cash to the firm from sales operations, returns on outside investments?, and so on. These receipts and payments constitute a continuous two-way flow of cash. But the inflows (receipts) and outflows do not perfectly coincide or synchronize. At times, receipts exceed outflows while, at other times, payments exceed inflows. To ensure that the firm can meet its obligations when payments become due in a situation in which disbursement are in excess of the current receipts, it must have an adequate cash balances. The requirement of cash balances to meet routine cash needs is known as the transaction motive and such motive refers to the holding of
7
CASH MANAGEMENT
cash to meet anticipated obligations whose timing is not perfectly synchronized with cash receipts. 2) PRECAUTIONARY MOTIVE In addition to the non-synchronization of anticipated cash inflows and outflows in an ordinary course of business, a firm may have to pay cash for purposes which cannot be predicted or anticipated. The unexpected cash needs at short notice may be the result of: ? ? ? ? Floods, strikes and failure of important customers; Bills may be presented for settlement earlier than expected Cancellation of some order for goods as the customer is not satisfied; Sharp increase in the cost of raw material.
The cash balances held in reserve for random and unforeseen fluctuations in cash flows are called as precautionary balances. In other words, 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. 3) SPECULATIVE MOTIVE It refers to the desire of a firm to take advantage of opportunities which present themselves at unexpected moments and which are typically outside the normal course of business. While precautionary motive is defensive in nature in that firms must make provisions to tide over unexpected contingencies, the speculative motive represents a positive and aggressive approach. Firms aim to exploit profitable opportunities and keep cash in reserve to do so. The speculative motive helps to take advantage of: ? An opportunity to purchase raw materials at a reduced price on payment of immediate price; ? A chance to speculate on interest rate movements by buying securities when interest rates are expected to decline; ? Delay purchases of raw materials on the anticipation of decline in prices; ? Make purchase at favorable price.
8
CASH MANAGEMENT
4) COMPENSATING MOTIVE Yet another motive to hold cash balances is to compensate banks for providing certain services and loans. Banks provide a variety of services to business firms, such as clearance of cheque, supply of credit information, transfer of funds, and so on. While for some of these services banks charge a commission or fee, for others they seek indirect compensation. Usually clients are required to maintain a minimum balance of cash at a bank. Since these balances cannot be utilized by the firms for transaction purposes, the banks themselves can use the amount to earn return. Such balances are called as compensation balances. Of the four primary motives for maintaining cash balances, the two most important are transactions motive and the compensating 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.
Cash Budget : A Management Tool
A firm is well advised to hold adequate cash balances but should avoid excessive balances. The firm has, therefore, to assess its needs for cash properly. The cash budget is probably the most important tool 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 sub period to another is highlighted by the cash budget. The various purposes of cash budgets are: 1. To coordinate the timings of cash needs. It identifies the period when there might either be a shortage of cash or an abnormally large cash requirement. 2. It pinpoints the period when there is likely to be excess cash. 3. 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. 4. It helps to arrange needed funds on the most favorable 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.
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Elements/Preparation of Cash Budget:
The principle aim of 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 cash budget involves various steps. These may be described as the elements of the cash budgeting system. The first element of a cash budget is the selection of the period time to be covered by the budget. It is referred 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 nor too short. If it is too long, it is likely that the estimates will be inaccurate. If, on the other hand, the time span is too small, many important events which lie just beyond the period cannot be accounted for and the work associated with the preparation of the budget becomes excessive. The planning horizon of a cash budget should be determined in the light of the circumstances and requirements of a particular case. For instance, if the flows are expected to be stable and dependable, such a firm may prepare a cash budget covering a long period, say, a year and divide it into quarterly intervals. In the case of a firm whose flows are uncertain, a quarterly budget, divided into monthly intervals, may be appropriate. Where flows are affected by seasonal variations, monthly budgets, subdivided on a weekly or even a daily basis, may be necessary. If the flows are subject to extreme fluctuation, even a daily budget may be called for. The idea behind subdividing the budgeting period into smaller intervals is to highlight the movement of cash from one sub period to another. The subdivision will provide information on the fluctuations 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 purpose of the construction of cash budget, into two broad categories: (a) Operating, and (b) Financial. This two fold classification of cash budget items is based on their nature. While the former category includes cash flows generated by the operations of the
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firms and are known as operating cash flows, the latter consists of financial cash flows.
Cash management: basic strategies
The cash budget, as a cash management tool, helps the management to know the net cash position of a firm so that the management can work out the basic strategies to be employed to manage its cash. The broad cash management strategies are essentially related to the cash turnover process, that is, the cash cycle together with the cash turnover. The CASH CYCLE refers to the process by which cash is used to purchase materials from which are produced goods, which are then sold to the customers, who later pay the bills. The firm receives cash from customers and the cycle repeats itself. The CASH TURNOVER means the number of time the cash is used during each year. MINIMUM OPERATING CASH The higher the cash turnover, the less is the cash a firm requires. A firm should, therefore, try to maximize the cash turnover. But it must maintain a minimum amount of operating cash balance so that it does not run out of cash. The firm should maintain a minimum level of operating cash so that it would not have to borrow anything. But minimum operating cash involves a cost in terms of the earnings foregone from investing in temporarily, that is to say, there is an opportunity cost. The minimum level of operating cash is determined by dividing the total annual outlays by the cash turnover rate. Cash management strategies are intended to minimize the operating cash balance requirement. The basic strategies that can be employed to do the needful are as follows: (a) (b) (c) (d) Stretching accounts payable. Efficient inventory production management. Speedy collection of accounts receivable, and Combined cash management strategies. In other words, efficient cash management implies minimum cash balance consistent with the need to pay bills when they become due.
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(a) Stretching Accounts Payable. A firm should pay its accounts payable as late as possible without damaging its credit standing. It should, however, take advantage of the cash discount available on prompt payment. (b) Efficient Inventory Production Management Another strategy is to increase the inventory turnover, avoiding stockouts, that is, shortage of stocks. This can be done in the following ways: 1. Increasing the raw material turnover by using more efficient inventory control techniques. 2. Decreasing the production cycle through better production planning, scheduling and control techniques. It will lead to an increase in the work-inprogress inventory turnover. 3. Increasing the finished goods turnover through better forecasting of demand and a better planning of production. (c) Speedy Collection of Accounts Receivable Yet another strategy of cash management is to collect accounts receivable as early as possible without losing future sales because of high-pressure of collection techniques. The average collection period of receivable reduced by changes in: (i) (ii) (iii) Credit terms. Credit standards, and Credit policies.
In brief, CREDIT STANDARDS represents the criteria for determining to whom credit should be extended. The COLLECTION POLICIES determines the effort put forth to collect the accounts receivable promptly. (d) Combined Cash Management Strategies.
The three basic cash management strategies, related to 1. 2. Accounts payable Inventory and
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3. Accounts receivable, lead to a reduction in the cash balances. But, they simply problems for the management. They are as follows: 1. If the accounts payable are postponed too long, the credit standing of the firm may be adversely affected. 2. A low level of inventory may lead to a stoppage of production as sufficient raw materials may not be available for uninterrupted production, or the firm may be short of enough stock to meet the demand for its product, that is, stock-out. 3. Restrictive credit standards, credits terms and collection policies may jeopardize sales. These implications should be constantly kept in view while working out cash management strategies.
Cash Management in Troubled Times
Many small business experience cash flow difficulties, especially during their first years of operation. But entrepreneurs and managers can take steps to minimize the impact of such problems and help maintain the continued viability of the business. Suggested steps to address temporary cash flow problems include:
1. Create a realistic cash flow budget that charts finances for both the short 2.
term (30-60 days) and longer term (1-2 years). Redouble efforts to collect on outstanding payments owed to the company. "Bill promptly and accurately," counseled the Journal of Accountancy. "The faster you mail an invoice, the faster you will be paid…If deliveries do not automatically trigger an invoice, establish a set billing schedule, preferably weekly." Businesses should also include a payment due date. Offer small discounts for prompt payment. Consider compromising on some billing disputes with clients. Small business owners are understandably reluctant to consider this step, but in certain cases, obtaining some cash—even if your company is not at fault in the dispute—for products sold/services rendered may be required to pay basic expenses. Closely monitor and prioritize all cash disbursements. Contact creditors (vendors, lenders, and landlords) and attempt to negotiate mutually satisfactory arrangements that will enable the business to weather its cash shortage (provided it is a temporary one). In some cases, you may be
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3. 4.
5. 6.
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able to arrange better payment terms from suppliers or banks. "Better credit terms translate into borrowing money interest-free," states the Journal of Accountancy. 7. Liquidate superfluous inventory. 8. Assess other areas where operational expenses may be cut without permanently disabling the business, such as payroll or goods/services with small profit margins. "Every operation struggling for survival is losing money in some of its components,"
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