Cash Management: Everything you need to know about  Cash Management!

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


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Cash is the most momentous component of working capital and is the most liquid form of business assets. Cash is not the only financial matter in a firm’s economic life it is the hub around which all other financial matters resolve. The working capital cycle starts with cash and also ends with the realization of cash; we start business with cash, produce goods and sale them to trade debtors, which are ultimately realized in cash and the cycle is repeated again and again.

Thus, cash is the starting and finish­ing point of a business. The position of cash in this sense may be compared to the blood of human-body because cash provides profit and solvency to the business organizations. A financial manager should plan his cash and credit sources in such a way that the normal business operations will not be disrupted by a shortage of cash and opportunities for capital expenditure are not cost because of an ability to finance them.

A financial manager has to adhere to the 5 R’s 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 organization can afford to pay.

The first is the question of how much cash should be held given the immediate and longer term needs of the maintenance and growth of the firm. Some firms hold balances of cash that appear to be well above their present or future investment needs. In United Kingdom, GEC is a leading example of this. For this year’s 1915-90 GEC’s net cash and assets employed with both relationships are shown in following exhibit.


Exhibit IV:

GEC’s Cash Position (Pound Million):

Years 1990 1989 1988 1987 1986 1985
Net Cash 879 1,116 1,042 1,036 661 599
AssetsEmployed 3,096 3,113 2,881 2,309 1,974 1,754
Percent­age of Cash to Assets 28.39 35.85 36.16 44.87 33.49 34.15

GEC is one of the UK’s most successful firms but long-term cash holdings of this size suggest to judge the returns to short- term investment outside the firm to be superior to internal opportunities. The management of cash and near cash is peculiarly important because it brings into sharp focus the trade-off between risk and return faced by a corporate finance manager.

The reasons for holding cash have traditionally been divided into three categories as postulated by Keynes. J.M. Keynes suggested three motives for liquidity-preference amongst investors: “the three divisions of liquity- perference . . . may be defined as depending on:


(i) The transaction motive, i.e., the need of cash for the current transaction of personal and business exchanges;

(ii) The precautionary motive, i.e., the desire for security as to a future cash equivalent of a certain proportion of total resources; and

(iii) The speculative motive i.e., the objective of securing profit from knowing better than the market what the future will bring a forth.”

Thus, the transaction motive is the need for cash (or bank overdraft facilities) to meet the payments arising in the ordinary course of business for things such as purchases, wages, taxes, dividends, etc. A firm needs a pool of cash because its inflows (receipts) and outflows (disbursements) are not perfectly synchronized.


The precautionary motive for holding cash has to do with maintaining a caushion or buffer to meet unexpected contingencies. The concern’s management takes into account expected losses and emergencies to decide the precautionary balance. This balance is laid for the rainy day.

The speculative motive relates to holding cash in order to get benefit of unexpected opportunities which are typically outside the normal course of business. Some money reserve is inevitable always that firm may be able to take advantage of cash when oppor­tunities are ripe and must be immediately knocked out.

A corporate financial officer plans for effective cash manage­ments keeping in view some basic purposes: meeting the operational requirements, maintaining bank relationship, providing liquidity reserve, building an investment image, exploiting profitable opportunities, and constructing a reservoir for net cash inflows.

Determining the optimum cash level is not a static process, it is a dynamic process. It is worthwhile for financial management to keep a diary of following significant occurrences to ascertain the cause and effect relationship in cash flows: availability of trade credit, position of account receivables, nature of business, sales pattern, status of inventory, tax on profits, management attitude, coincidence of cash flows, payment policy, borrowing capacity, relation with banks, etc. Taking into consideration all the factors determining cash balances a cash flow forecast is made which is called cash budget.


A cash budget is a statement showing the estimated cash receipts and disbursements over the firm’s planning horizon. In simple words, its basic idea is to predict when and what quantity, the receipts of cash would come into firm and when and in which quantity, payments in cash would be made. Some authors advocate the use of statement of sources and uses of funds to aid working capital management and cash control.

Model-building approaches to cash management:

One of the first inventory models for management of cash and marketable securities is that of William J. Baumol, which assumes:

(i) A firm’s consumption of cash follows the ‘saw-tooth’ pattern, i.e., cash is consumed at a constant rate and is replenished occasionally by the injection of a fixed amount of cash from deposits or the sale of securi­ties,


(ii) We can calculate a percentage ‘carrying cost’ per period per cash, and

(iii) There is a fixed cost of replenishing cash. Baumol’s model is given below:

Q= √2 DO/C



Q=optimal quantity of cash to raise at a time,

D—total requirements for cash in the period,

0=fixed transaction cost, and

C=the rate of interest during the period.

This model determines the amount of the transfer between marketable securities and cash for various sub-periods. James Tobin developed a similar model to Baumol with certain modifications. Tobin was interested in the interest elasticity demand for cash for a specified volume of transactions.

Accord­ing to Tobin’s view a firm or an individual holds transaction balance in either cash (a non-earning asset) or in bonds (an earning asset). Tobin’s model involves a determination of the optimal average cash and bond holdings.

The Miller—Orr’ model:

Merton H. Miller and Daniel Orr have developed a more sophisticated cash management model for that situation where the firm’s inflows and outflows of cash are unpredictable. This model expands upon the basic cash inventory model by assum­ing that the net cash flows are random in direction and they form a normal distribution as the number of observations increase. Miller—Orr model allows for a prior knowledge that a certain times the net cash flows have a greater probability of being either positive or negative.


The main improvement of this model over the basic inventory model is that it can represent real-life cash-flow process. The model allows the cash balance to wander freely between a limit, as long as the balance stays between these limits, no action is taken. The model calculates upper and lower control limits for cash.

If and when the balance reaches the upper limit U, a transfer is made into marketable securities such that the cash balance falls to level Z, if the cash balance reaches the lower limit L, a sale of marketable securities is made in order to replenish cash to the level Z. Thus, the model sets three points of cash balances; upper, lower and control or return. The objective for the model is to maximize earnings by finding optimal levels of U and Z with the help of the following formula:

Z= (3aσ2) 1/3 / (4 i)


U=3 Z (i.e., the upper control limit U is always 3 times than the amount Z the control limit)


a=cost per transfer between cash and marketable securi­ties,

σ2=variance of daily cash flows, i=daily rate of return on the securities.

To use the model, authentic and true data is required and this may be difficult from operational point of view. W. Beranek has developed a probabilistic model for controlling cash which involves management specifying probabilistic outcomes for net cash flows based on prior knowledge and experience. D.J. White and J.M. Norman also favoured Beranek model.

Cash management processes:

Liquidity management strategies are essentially related to the cash turn-over process, i.e., the cash cycle together with the cash turn-over. According to Solomon and Pringle, “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 customers, who later pay bills.

The firm receives cash from customers and the cycle repeats itself.” The cash cycle involves payment of raw materials, wages and overheads; production of goods; sales to customers; and the collection of accounts receivables. Management can use various ratios to examine the use of case in the business activities. One often-quoted is that of cash turn-over or cash velocity ratio:

Cash Turnover = Sales per Period / Initial Cash Balance


The higher the turnover, the less the cash balance required for any given level of sales and, other things being equal, implies greater efficiency. The ratios should be computed at various times in the year, especially if the business is seasonal, and can be compared against prior-year statistics; any unexpected deviations should be investigated.

The strategic aspects of efficient cash management are:

1. Efficient inventory management,

2. Speedy collection of accounts receivable, and

3. Delaying payments of accounts payable.

The main techniques of efficient inventory management are discussed in the preceding sections. There are some general and some specific techniques and process for speedy collection of receivables from customers and slowing disbursements. The major techniques or tools of cash management, which can b& adopted by the firm are:

The lockbox system:

The purpose of the lockbox arrangement is to eliminate the time delays caused by long distance and mailing (commonly known as float) and to converse payment into cash soon. A lockbox is Post Office box kept in a distant location to which the firms’ customers in that geographical location send their cheques.


The box is opened each day or several times a day by the firm’s bank and the account credited. Thereafter, banks convey this information quickly to the firm by telegraphic means. In this way postal delays are reduced by regional mailing, and ‘paying in’ delays are eliminated because the cheques are already in bank.

According to the agreement with each regional ‘lockbox bank’ funds in excess of the minimum balance maintained, to cover costs either are transferred to the firm’s headquarters’ bank, or less frequently are drawn off by the financial manager at his discretion.

Concentration banking:

In this system of concentration large firms establish strategic collection centres to speed up their collection procedures. Collections are made locally by sales branches or offices, divisions or subdivisions, and deposited in local bank accounts. Under this system, the funds beyond a pre-determined limit are transferred periodically central office or bank account.

The net result is to decrease the size of ‘float’ in accounts receivables and to make these funds available to the head office several days before. Concentration banking may be combined with the lockbox system for speeding cash collections or it may be used in lieu of a lockbox system.

Airmail pouch system:

Aside from the lockbox and similar collection system, as express clearance of cheques, direct debiting agreement with the client; unusual techniques are sometimes employed, particularly for collection of a large single sum.


One such device is airmail pouch service with a superfast media for speedy cash collections. For instance, an employee places a customer’s cheque on domestic flight from Calcutta to Madras bank on the day that it is received. But this system involves a heavy cost so the use of this technique can be justified in some special circumstances.

Centralised disbursements:

The velocity of cash can be increased by controlling or slowing disbursements of accounts payable also. The firm shall make a policy that all the payments small be made by the Head Office from a centralized disbursement account through crossed cheques on a fixed day and time only. Thus, all this process will result in increase in the transit time and delayed payments.


Float arises from the delay between the time a cheque is written and the time it is cleared by the bank. Float represents the difference between the balance as shown by the firm’s record and the actual bank balance. There is a time-lag between the issue of a cheque by the firm and its presentation to its bank by the customer’s bank for payment.

The implication is that although a cheque has been issued, cash would be required later when the cheque is presented for encashment. Therefore, a firm can send remittances although it does not have cash in its bank at the time of issuing the cheque.

According to Khan and Jain funds can be arranged to make payment when the cheque is presented for collection after a few days. By increasing creditors’ float i.e., stretching accounts payable firm gets a source of funds without interest charges.

The existing cash management practices differ from industry to industry and firm to firm. Some firms keep a generous amount of cash so that the firm besides meeting emergencies be in a position to reap the benefit by purchasing huge quantities of materials when market is down. On the other hand, some firms do not maintain a minimum cash balance, hence always remain pressed for cash and arrange only when requirements fall due.

A wise step in this connection is to have a middle way i.e., a reasonable optimal cash balance should always remain there. Excess, if any, be kept invested in suitable short term investments, which may have ready market in case of require­ment. But there does not seem any magic formula which can determine optimum level of cash but some broad guidelines are suggested by authorities on finance, which have been mentioned above.

Working capital management is an integral part of overall corporate management. To a financial manager, a working capital sphere throws a welcome challenge and opportunity. In view of the multiplicity of factors exerting varied degrees of influence on working capital studies, the management has to be alert to the internal, external and environmental developments, and constantly plan and review its working capital needs and strategy.

Working capital management has been looked upon as the driving seat of a financial manager. Moves and actions in the operating fields of production, procurement, marketing and services are ultimately interpreted and viewed in financial terms, hence the preoccupation with the financial implications of the management of working capital and its segments.

In this connection Louis Brandt observes, “We need to know about whither to look for working capital funds, how to use them and how to measure, plan and control them.”The analysis, control and optimization techniques for major components of working capital viz., inventories, debtors and cash, are set out in separate segments. Modern financial management recognizes that the various assets of the firm are inextricably interwoven, intermingled and dependent upon each other.