Cash Management

CASH MANAGEMENTCASH MANAGEMENT

OVERVIEWOVERVIEW

I. INTRODUCTION

II. CASH FLOAT

III. MILLER-ORR CASH MODEL

IV. BAUMOL MODEL

V. CONCLUSION

I. I. INTRODUCTION INTRODUCTIONCash and liquidity is the lifeblood of any organisation. Cash and liquidity is the lifeblood of any organisation.

Cash and net income are two very different financial concepts.Cash and net income are two very different financial concepts.

Liquidity is need for:Liquidity is need for:

Day to day transactions;Day to day transactions; Precautionary balances;Precautionary balances; Speculation balances;Speculation balances; Compensating balances;Compensating balances; Obtaining discounts;Obtaining discounts; Acid tests;Acid tests; Avoiding Liquidation and ReceivershipAvoiding Liquidation and Receivership

INTRODUCTIONINTRODUCTIONCash management problems may occur for a Cash management problems may occur for a

number ofnumber offoreseen reasons:foreseen reasons:

Overtrading;Overtrading; Growth;Growth; Inflation;Inflation; Payment Delays;Payment Delays; Bad Debts;Bad Debts; Large Items of Expenditure;Large Items of Expenditure; Seasonal Trading.Seasonal Trading.

INTRODUCTIONINTRODUCTION

There are a number of unforeseen factors that affect There are a number of unforeseen factors that affect the levels of cash held by a public organisation:the levels of cash held by a public organisation:

New Competitors and/or new products;New Competitors and/or new products; Consumers may change their purchasing habits;Consumers may change their purchasing habits; Changes in interest rates;Changes in interest rates; Reversing past investment decisions;Reversing past investment decisions; Industrial Action.Industrial Action.

INTRODUCTIONINTRODUCTION

Remedies to deal with short-term cash shortages Remedies to deal with short-term cash shortages are:are:

Accelerating cash inflows from debtors;Accelerating cash inflows from debtors; Postponing cash outflows by delaying payment to Postponing cash outflows by delaying payment to

creditors;creditors; Postponing capital expenditurePostponing capital expenditure Reversing past investment decisions;Reversing past investment decisions; Rescheduling loan repayments.Rescheduling loan repayments.

INTRODUCTIONINTRODUCTION

The two main cash ratios are:The two main cash ratios are:

(a) Cash Holding (a) Cash Holding = = CashCash

Current AssetsCurrent Assets

(b)(b) Cash TurnoverCash Turnover == TurnoverTurnover

Average Cash BalanceAverage Cash Balance

II. CASH FLOATII. CASH FLOAT

A float is the time lost between a payer making a A float is the time lost between a payer making a payment and a beneficiary receiving valuepayment and a beneficiary receiving value

The Cost of the Float is:The Cost of the Float is:

principle amount due principle amount due x x no of daysno of days x cost of x cost of fundsfunds

360 or 365360 or 365

Any delay in the process of converting inventory to Any delay in the process of converting inventory to receipt of payment results in a float cost;receipt of payment results in a float cost;

Similarly, any delay in making payments will also Similarly, any delay in making payments will also give rise to float but this time to our advantage.give rise to float but this time to our advantage.

CASH FLOATCASH FLOAT

Function Float Responsibility

1. Order received Production float

2. Goods dispatched System float

3. Invoice issued Credit period

4. Payment due Customer float

5. Payment made Postal float

6. Payment received System float

7. Payment banked Bank float

8. Funds available Concentration float

9. Funds to correct account Information float

10. Advice of availability  

Supplier

Supplier

Supplier

Buyer

Buyer/ postal service

Supplier

Banks

Banks

Banks

III. MILLER-ORR CASH MODEL

The Miller-Orr model manages the cash position of an organisation where it’s cash levels are not entirely predictable.

Under the model, the organisation allows the cash balance to fluctuate between the upper control limit and the lower control limit, making a purchase and sale of marketable assets only when one of these limits is reached.

The assumption made here is that the net cash flows are normally distributed with a zero value of mean and a standard deviation.

MILLER-ORR CASH MODEL

This model provides two control limits – the upper control limit and the lower control limit as well as a return point.

When the firm’s cash limit fluctuates at random and touches the upper limit, the firm buys sufficient marketable securities to come back to a normal level of cash balance i.e. the return point.

Similarly, when the firm’s cash flows wander and touch the lower limit, it sells sufficient marketable securities to bring the cash balance back to the normal level i.e. the return point.

MILLER-ORR CASH MODEL

The organisation allows its cash balance to wander randomly between upper and lower control limits.

£

Time

H

Z

L

When the cash balance reaches the upper control limit H cash is invested elsewhere to get us to the target cash balance Z.

When the cash balance reaches the lower control limit, L, investments are sold to raise cash to get us up to the target cash balance.

MILLER-ORR CASH MODEL

To use the Miller-Orr model, the manager must doTo use the Miller-Orr model, the manager must do

four things:four things:

1.1. Set the lower control limit for the cash balance.Set the lower control limit for the cash balance.

2.2. Estimate the standard deviation of daily cash Estimate the standard deviation of daily cash flows.flows.

3.3. Determine the interest rate. Determine the interest rate.

4.4. Estimate the trading costs of buying and selling Estimate the trading costs of buying and selling securities.securities.

MILLER-ORR CASH MODEL

Given Given LL, which is set by the firm, the Miller-Orr , which is set by the firm, the Miller-Orr model solves for model solves for Z Z and and HH

LK

FσZ 3

2*

4

3 LZH 23 **

where 2 is the variance of net daily cash flows.• The average cash balance in the Miller-Orr model

is

3

4balancecash Average

* LZ

IV THE BAUMOL MODELIV THE BAUMOL MODELBaumol’s cash management model helps in determining a Baumol’s cash management model helps in determining a

firm’sfirm’soptimum cash balance under certainty. As per the model, cash optimum cash balance under certainty. As per the model, cash

andandinventory management problems are one and the same. inventory management problems are one and the same.

There are certain assumptions that are made in the model:There are certain assumptions that are made in the model:

1. The organisation is able to forecast its cash requirements 1. The organisation is able to forecast its cash requirements with certainty and receive a specific amount at regular with certainty and receive a specific amount at regular intervals.intervals.

2. The organisation’s cash payments occur uniformly over a 2. The organisation’s cash payments occur uniformly over a period of time.period of time.

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

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

THE BAUMOL MODELTHE BAUMOL MODEL

Opportunity Costs

Trading costs

Total cost of holding cash

C

Cost of holding cash

Size of cash balance

The investment income foregone when holding cash.

Trading costs increase when the firm must sell securities to meet cash needs.

THE BAUMOL MODELTHE BAUMOL MODEL

B = The fixed cost of selling securities to raise cash

N = The total amount of new cash neededC = The opportunity cost of holding cash (The

interest rate)

Time

C

1 2 3

C2–

THE BAUMOL MODELTHE BAUMOL MODELQ = maximum cash balance

Q/2 = average cash balance

B = transaction costs for selling securities or arranging a loan

N = total amount of new cash needed for the period under consideration

C = the holding cost of cash opportunity cost

The total cost line consists of the following:Average amount Opportunity Number of Cost of each

tied up cost transactions transactionx + x

2CA –––––K

Q N2

+Q

x C x B

Q =

THE BAUMOL MODELTHE BAUMOL MODEL

Example

Education for Everyone is a charity that pays out £100,000 per week and receives an inflow of £80,000 – additional cash need £20,000 where the opening cash balance is £80,000. Use the Miller-Orr Model to successfully manage their cash position.

THE BAUMOL MODELTHE BAUMOL MODEL

Answer

•Interest rate forgone, K, is 7 per cent

•Annual need for cash is (£20,000 × 52) = £1,040,000

•Number of times replenishment will take place each year:

A/Q* = £1,040,000 / £121,890

–––––––––––––––––– = £121,890 0.07

2 × £500 × £1,040,000Q* =

V.V. CONCLUSIONCONCLUSION Cash and liquidity is vital to any organisation and has a Cash and liquidity is vital to any organisation and has a

number of roles to play;number of roles to play;

There are a number of foreseen/unforeseen reasons why an There are a number of foreseen/unforeseen reasons why an organisation may have cash flow problems and consequential organisation may have cash flow problems and consequential remedies;remedies;

The cash float of an organisation should be minimised;The cash float of an organisation should be minimised;

Cash flow forecasts and cash budgets are a vital in the Cash flow forecasts and cash budgets are a vital in the financial planning of a public sector organisation;financial planning of a public sector organisation;

There are two cash management models – Miller-Orr and the There are two cash management models – Miller-Orr and the Baumol.Baumol.