Cash Management and Working Capital

Cash is the medium of exchange on the common purchasing power and which is the most important component of working capital. It includes coins, currency, cheques held by the firm and the balances in its bank accounts. Sometimes near-cash items also are included.’ Cash is the basic input required to keep the firm running on a continuous basis.

At the same time it is the ultimate output expected to be realized by selling goods and services A firm should hold sufficient cash, neither more, not less. Excessive cash remains idle which simply increases the cost without contributing anything towards the profitability of the firm and in the opposite case, trading and/ or manufacturing operation will be disrupted.

Not only that, it largely upholds, under given condition, the quantum of other ingredients of working capital, viz., inventories and debtors, that may be needed for a given scale and type of operation.

Cash is, no doubt, a most important asset and that is why a firm wants to get hold of it in the shortest time possible. In the absence of sufficient quantity of cash at the proper time, payment of bills including dividend and others, may not have to be made.

It is interesting to note that cash management involves the three following factors:

(i) Ascertainment of the minimum cash balance;

(ii) Proper arrangement to be made for collection and payment of cash in such a way so that minimum balance can be maintained; and

(iii) Surplus cash to be invested in temporary investments or to be invested in fixed assets.

Similarly, cash is not productive directly like other assets, viz., it is sterile. For example, fixed assets are acquired for the purpose of earning revenue. Accounts receivables are generated by granting credit to customers etc.

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 current/liquid assets, viz., receivables, inventories etc., get eventually converted into cash.

It is the significance of cash management which is the key area of working capital management Cash management is important since it is very difficult to estimate correctly the inflow of cash. Practically, it is not so easy to make a proper synchronization of inflows and outflows of cash.

For this purpose, the firm should develop some strategies for cash management for the following:

(a) Cash Planning:

A cash budget should be prepared for ascertaining the cash surplus or deficit for each period of planning through the inflows and outflows of cash.

(b) Managing the Cash blows:

The flow of cash (inflow and outflow) should properly be managed so that the synchronization between inflows and outflows is possible.

(c) Optimum Cash Level:

The optimum level of cash should always be maintained, i.e., the appro­priate level of cash balances should be determined.

(d) Investing Idle Cash:

The excess or idle cash should properly be invested in order to earn profit.

Motives for Holding Cash:

Keynes has identified three following motives for cash:

(i) The transactions motive;

(ii) The precautionary motive, and

(iii) The speculative motive

(i) The Transactions Motive:

This motive refers to the holding of cash in order meet the day-to-day transactions which a firm carries on in the ordinary course of the business. Primarily, these transactions include purchase of raw materials, wages, operating expenses, taxes, dividends etc. We all know that a firm may enter into a variety of transactions to accomplish its objectives. Similarly, there is regular inflow of cash from revenues.

Thus, the receipts and payments constitute a conti­nuous two-way flow of cash Since the inflows and outflows of cash do not perfectly synchronize, an adequate or a minimum cash balance is required to uphold the operations if outflows exceed the inflows. Therefore, in order to meet the day-to-day transactions, the requirement of cash is known as transaction motive.

So, it refers to the holding of cash to meet anticipated obligations when timing is not perfectly synchronized with the inflows of cash. Although, a major part of transactions balances is held in cash, a part may also be held in the form of marketable securities whose maturity conforms to the timing of the anticipated payments, such as payment of taxes, dividends etc.

(ii) The Precautionary Motive:

This motive for holding cash has to do with maintaining a cushion or buffer to meet unexpected contingencies. The unexpected cash needs at short notice may be the result of

(a) Uncontrollable circumstances, such as, floods, strikes, droughts etc.;

(b) Bills which may be presented for settlement earlier than expected;

(c) Unexpected delay in collection of trade dues;

(d) Cancellation of some order for goods due to inferior quality; and

(e) Increase in the cost of material, labour etc.

Precautionary balances are the cash balances which are held as reserve for random and unforeseen fluctuations in cash flows, i.e., this motive implies the need to hold cash to meet unpredictable obligations. The more predictable the cash flows, the less precautionary balances that are needed and vice-versa.

Moreover, the need for this types of cash balance may be reduced if there is already borrowing power in order to meet the emergency cash outflows. Sometimes a portion of such cash balances may be held in marketable securities, i.e., near-money assets.

(iii) The Speculative Motive:

This motive refers to the holding of cash for taking advantages of expected changes in security price In other words, when the rates of interest are expected to fall, cash may be invested in different securities so that the firm will benefit by any subsequent fall in interest rates and rise in security prices.

On the other hand, when the rates of interest are expected to rise, the firm should hold cash until the rise in interest rates ceases. The precautionary motive is defensive in nature while speculative motive represents a positive and aggressive approach.

The speculative motive helps to take advantages of:

(i) An opportunity to purchase raw materials at a reduced price against imme­diate payment, i.e., benefit of cash discounts;

(ii) A change to speculate of interest rate movements by purchasing securities when rates of interest are expected to decline;

(iii) The purchase at favourable prices.

The Level of Cash Balance:

Adequate cash balance should always be maintained by a firm. But it does not mean that the firm should hold excessive cash balance since it is a non-earning asset Excessive cash balance will not only impale the firm’s profitability but also gives a lower asset turnover ratio. Therefore, optimum cash balance should be maintained by a firm.

For this purpose, two factors are to be considered, viz:

(a) Compensating Balances, and

(b) Self-imposed Balances,

(a) Compensating Balances:

Banks serve different types of services to the firms, e.g., clearance of cheque, transfer of funds etc., against a nominal commission or fee. Generally, clients (firms) are required to maintain a minimum cash balance at the bank which cannot be utilized by them for transaction purposes’. The bank can use the same to earn a return.

In other words, in order to compensate the services rendered by the banks, clients/firms are required to keep a balance which will be sufficient to earn a return equal to the cost of services. Such balances are known as compensating balances.

Sometimes, compensating balances are also maintained when loans are granted by a bank to its customers, particularly when the supply of credit is restricted and the rate of interest is raising. In short, a borrower must have to maintain a minimum balance at bank in order to compensate the bank against the risk of interest rate.

Therefore, compensating balances take the following form:

(i) An absolute minimum:

Say Rs 10 lakhs, below which the bank balance will never be allowed to fall.

(ii) A minimum average balance:

Say Rs 10 lakhs, over a particular period, e.g, one month.

(b) Self-imposed Balances:

Self-imposed balance is determined in order to consider the following factors:

(i) The need for cash and its predictability;

(ii) Interest rate or borrowing rate on marketable securities;

(iii) The fixed cost of effecting a transfer between cash and marketable securities.

However, the following models are used for determining the self-imposed balance:

(a) Operating Cycle Model;

(b) Inventory Model;

(c) Stochastic Model; and

(d) Probability Model

(a) Operating Cycle Model:

The operating cycle concept of working capital states that the higher the cash turnover, the lower will be the requirements for cash and vice-versa. It has also been mentioned that the optimum requirement of cash needed by a firm is determined by dividing the firm’s total annual expenditures by the cash-turnover rate.

The following illus­tration will make the principle clear:

(b) Optimum Cash Balance using Inventory Model:

The economic order quantity formula (EOQ) which is used in inventory manage­ment provides a useful conceptual foundation for the cash management problem. In this model, the carrying cost of holding cash (viz the interest forgone on marketable securities) is balanced against the fixed cost of transferring marketable securities to cash or vice-versa.

When a firm holds too small cash balance, it runs out of costs, i.e., costs of running short of cash, the elements of which are:

(i) Cost of passing up trade discounts.

(ii) Cost of passing up quantity discounts;

(iii) Cost of becoming delinquent; and

(iv) Cost of failure to meet payroll on time or to make interest and principal payment when due

However, if there is a shortage of cash, marketable securities are liquidated or fresh borrowing can be made. Both of them require procurement costs which is inclusive of fixed costs related with the transaction. Moreover, in addition to running cost, a portion of general fixed cost may also be included Similarly, when a firm holds too high a cash balance, it may have to incur either opportunity cost or borrowing cost.

They will also arise from all other assets that have been passed up in favour of holding the cash as cash and from liabilities that continue to be outstanding because cash is not used to pay them off. No doubt, borrowing costs are the financing costs related with borrowings.

Now, the question arises before us is that which one is taken advantages of— selling short- term securities into cash or borrowing? Because, sometimes, it becomes cheaper to sell short-term securities’ while it may be wise to borrow from banks at times. Therefore, if the firm does not possess any short-term securities which can be sold, it can borrow from bank

The ‘cost of carrying’ may be represented as opportunity/borrowing cost while ‘cost of not carrying’ represents transaction/short costs It is to be remembered that the optimum cash balance is the balance where cost of carrying or opportunity cost becomes equal to the cost of not carrying or transaction cost.

At this level, the total costs, i.e., the sum of opportunity cost/borrowing cost and transaction/short costs become minimum Thus, a firm should always maintain an optimum cash balance, neither a small nor a large Fig 8.8 shows the optimum cash balance.

Fig.8.8 shows that when the firm maintains a large cash balance, its transaction costs will decline but the opportunity cost will tend to rise Point P, shows the optimum position of cash and where the total costs are minimized

(c) Stochastic Models:

Where the uncertainty of cash payment is large, i.e., the future is unknown with certainty, the EOQ models may not be applicable. Naturally, in order to determine optimum behaviour other models should be used assuming that the demand for cash is stochastic and unknown in advance Control theory can be applicable where cash balances fluctuate widely.

One can set control limits such that when cash reaches an upper limit a transfer of cash to marketable securities is consummated, when it hits a lower limit a transfer from marketable securities to cash is triggered. Setting the control limits it depends upon the fixed cost associated with securities transaction and the opportunity cost of holding cash.

There are a number of control theories to the problem. The relatively simple one is ‘The Miller-Orr model’ which specifies two control limits — ‘h’ amount as an upper bound and zero amount as a lower bound The model is illustrated in Fig. 8.9.

It is evident that if cash balance touches the upper bound, h — z rupees of marketable securities are purchased and as such, new balance becomes z rupees. On the contrary, if cash balance touches zero, z rupees of marketable securities are sold and the new balance becomes again z. The minimum bound can be set at some amount higher than zero, and h and z will move up in the figure accordingly.

This model gives an answer relating to the minimum and maximum balances. It should be mentioned that the solution for optimum value of h and z depend upon the fixed and opportunity cost along with the degree of likely fluctuation in cash balances.

The optimum value of h is simple 3z.

With these control limits, this model minimizes the total costs (fixed and oppor­tunity) of cash management. The average cash balance cannot be determined exactly but the same is approximately (z+h/3). The average cash balance, according to this model, will be higher than that suggested by inventory model,

(d) Probability Model:

The EOQ model assumes that cash flows are predictable while the control-limit model assumes that they are random. But, in practice, cash flows are neither com­pletely predictable nor stochastic. On the other hand, they are predictable within a range. In the circumstances, probability distributions may be used for a range of possible outcomes and optimum cash balance may be ascertained accordingly.

Estimation of Cash Requirements:

No doubt, the primary step in cash management is to estimate the requirement of Cash.

For this purpose,

(a) Cash Flows and

(b) Cash Budgets are required to be prepared,

Cash Management:

Synchronization of Cash flows:

Now, the various collection and disbursement methods by which a firm can increase its efficiency in cash management are discussed in the present column Practically, these methods constitute two sides of same coin, they exercise a joint impact on the overall efficiency of cash management.

However, the efficiency of cash management depends upon:

(1) Speeding up collections of accounts receivables; and

(2) Delaying payments on accounts payable, i.e. deferring disbursements.

(1) Speeding up collections of accounts receivables:

In order to manage cash efficiently, the process of cash inflow can be accelerated through systematic planning and refined techniques. There are, however, two broad approaches to do this.

They are:

(a) The customers should be encouraged to pay as quickly as possible by introducing cash discounts;

(b) The payment from customers should be converted into cash without any delay, i.e., managing float to speed up collection.

(a) Prompt Payment by Customers:

Prompt billing is one of the ways for ensuring prompt payment by customers, i.e., the bill should be prepared correctly and notified to the customer concerned in advance mentioning the date of payment Mechanical devices for billing may be used for this purpose.

The other important technique for encouraging prompt payment is the practice of introducing cash discounts which is nothing but a saving to the customer.

(b) Managing Float to Speed Up Collection:

When the payment is made by the customers by issuing a cheque, the collection can be expedited by prompt encashment of the same. We all know that there is a time lag between the time a cheque is prepared and mailed by the customer and the actual realisation of the same.

Actually, three different floats are involved for this time interval:

(i) Postal/Mailing float;

(ii) Cheque processing float and

(iii) Bank float.

(i) Postal Mailing Float:

Postal float is the time taken by the post office messenger service or other means of delivery to transfer the cheque from the customers to the firm, i.e., the transit or mailing time which should be reduced as far as possible.

(ii) Cheque Processing Float:

The time which is taken in processing the cheque within the firm before they are deposited into bank is known as cheque processing float.

(iii) Bank Float:

The time taken by the bank in collecting the payment (i.e., collection time within the bank) from the customer’s bank, is called bank float. It should be mentioned in this respect that all the floats referred to above (i.e., postal, cheque, and bank) are known as deposit float.

It is defined as the sum of cheques written by customers that are not usable by the firm. No doubt, the collection of accounts receivable can be accelerated considerably by reducing the above floats, i.e., the reduction in deposit float. The same is possible only when the decentralized collection policy is being adopted by the firm.

Techniques to Overcome the Difficulties of Cash Management:

In order to overcome the difficulties discussed above, i.e., in reducing the span between the time a customer makes payment and the time such funds are available for use by a firm, two techniques are now-a-days used.

They are:

(1) Concentration Banking; and

(2) Lock-box System.

(1) Concentration Banking:

Under this system, the firms which have a large number of branches at different places, may select some of these which are strategically located as collection centres for recurring payment from different customers, i.e., multiple collection centres are established instead of a single collection centre.

The purpose of this system is to speed up the time in the collection process from customers. Customers in a particular geographic area are instructed to remit their payments to the specific collection centre in that area.

The establishment and the selection of collection centres, however, depends upon the volume of business and geographic areas served. Under this sys­tem, when payments are received, they are deposited in the local account of the concerned collection centre after meeting local expenses.

Surplus funds are then transferred from these local bank accounts to a central or disbursing or concentration bank. In short, a concentration bank is one with which the company has a major account— usually a disbursement account. In other words, collections are decentralized but disbursements are centralised.

The transfer of surplus funds may be made either by a wire or by a mail.

The choice between them, of course, depends on:

(i) The amount involved, and

(ii) Cost of finance.

It should be mentioned that wire transfers are economical when large sums are involved and the firm earn a reasonable return on short-term, low-risk and highly liquid investment.

The advantages of concentration banking are:

(i) The time required for mailing is reduced. Since the local collection centre prepares bills against the customers, the customer usually receives the bills earlier than if the bills were sent by the head office directly from a distant place.

At the same time, when customers pay their bills at the local collection centre instead of mailing the same to the head office, it will also reduce time. Thus, in this way, it is estimated that there will be a saving of approximately one day in mailing time.

(ii) The time taken for collecting the cheque is also reduced. When remittances are made at the banks, the collection centre transfers immediately by telegram to the company which enables the company to have the use of the funds without delay. Naturally, the company can release nearly double the amount of average daily remittance by saving the time taken in mailing and in the collection of cheques.

(iii) Moreover, the concentration bank permits the firm to ‘store’ its cash more efficiently.

Thus, concentration banking, as a decentralized billing and multiple collection points system, is a useful device to expedite the collection of accounts receivables

(2) Lock-Box System:

The alternative means of accelerating the flow of funds is a lock-box arrangement. In concentration banking, cheques are received by collection centres and deposited in the bank after processing so that mailing float is reduced. But there remains the cheque processing float.

It is needless to mention that lock-box system will eliminate the cheque processing float. Under this system, the firms hire a post office box under the control of a bank at important collection centres.

The customers are directed to remit their payments to the lock-box. The local banks are authorized to open the box and collect the remittances/cheques received from the customers. Normally, the bank so authorized to collect the cheques, pick up the cheques several times a day and deposits the same to the firm’s accounts.

The banks send a deposit slip together with the list of payments and other enclosures to the firm by way of proof record and information after crediting the respective account of the firm. After the realisation of cheques, surplus funds are transferred to the central account of the firm.

Lock-box system, in a sense, is like concentration banking since the collection is decentralized. One significant difference between the two is that, under a concentra­tion banking system, the customers send the cheques to the collection centre, while, under lock-box system, they send them to a post office box.

Thus, lock-box system is, no doubt, an improvement over the concentration banking system since under the former, one step in the collection process is being eliminated In short, processing time within the firm is eliminated before the actual deposit of a cheque into a bank. Therefore, extra saving in mailing time is possible as direct collection is made by bank

The lock-box system, as an improved method of collection for accounts receivables over the concentration banking, enjoys the following advantages:

(i) The primary advantages of a lock-box system are that the time lag between cheques are received by a company and they are actually deposited into bank, is eliminated.

On the contrary, the principal disadvantages of this system are the cost, which is charged by the bank for these additional services and as such, requires compensation for this purpose, usually preferring increased deposits. Therefore, this system is not feasible if there is unlimited remittances.

(ii) This system reduces the overhead expenses

(iii) It also facilitates control by separating remittance from the accounts section.

(iv) It also reduces the credit losses by expediting the time at which data are posted to the ledgers.

(ii) Delaying payments on accounts payable or, deferring disbursement:

Various items of payments may be differed till they affect the smooth running of the operation and at the same time, damage the goodwill of the firm. There are certain items, viz. Wages, Salaries etc., which are very difficult to defer payments. But the most significant item is the payment to creditors for this purpose.

Deferring disburse­ment (to the creditors) includes:

(a) Stretching the period of credit granted; and

(b) Using float

The first one which is granted by the creditors is considered unfit as it affects the credit reputation of the firm. Of course, in the absence of cash discounts, there is a good possibility that such costs are hidden in the prices of the goods which may be impossible to measure’. If discounts are available, the said amount of discount may be compared with the benefits which may accrue if the said payments are diverted elsewhere.

It is interesting to note that in the background of cash credit being heavily relied upon by the Indian firms in general for financing a part of current assets, the applicable interest rate will become one of the variables instead of opportunity cost in this decision area. If the full advantages of using all kinds of floats are taken, there will be a cash on hand for longer period.