Management of working capital (4) – Cash
1 Introduction
The purpose of this chapter is to discuss the reasons for the holding by a company of short-term cash balances, and to consider ways of managing these cash balances effectively.
2 Reasons for holding cash:
Transaction motive
Precautionary motive
Speculative motive
3 Methods of dealing with cash shortages:
Reduce inventories
Defer capital expenditure
Defer or reduce dividends
Chase receivables to pay earlier
Postpone the payment of payables
Use short-term borrowing (overdraft)
Sell surplus assets
Sale and leaseback
4 Cash surpluses
A cash surplus may arise over the short term, medium term, or long term.
Possible uses of surplus cash include:
4.1 Short term
Reduce overdraft
Invest in short-term Treasury Stock
Invest in bank deposit account
Invest in ‘blue-chip’ shares
4.2 Long term:
Invest in new projects
Acquire other companies
Increase dividends
Buy back shares
Repay long term loans
5 Cash Management models
5.1 Cash budgets
Cash budgets are probably the most important tool in practice for the management of any company’s cash position. They are vital to identifying in advance a likely deficit or surplus in order that appropriate action can be taken to avoid any problem or profit from any opportunity.
6 Cash budgets
6.1 Proforma
Period | 1 | 2 | 3 | 4 | 5 |
|---|---|---|---|---|---|
$ | $ | $ | $ | $ | |
Receipts | |||||
Cash sales | x | x | x | x | x |
Receipts from credit customers | x | x | x | x | x |
Other income | x | x | |||
x | x | x | x | x | |
Payments | |||||
Cash purchases | x | x | x | x | x |
Payments for credit purchases | x | x | x | x | x |
Rent and rates | x | x | |||
Wages | x | x | x | x | x |
Light and heat | x | x | |||
Salaries | x | x | x | x | x |
Telephone | x | x | |||
Insurance | x | ||||
x | x | x | x | x | |
Surplus/(deficit) | (x) | (x) | x | x | x |
Balance b/f | – | (x) | (x) | (x) | x |
Balance c/f | (x) | (x) | (x) | x | x |
Additionally, cash flows relating to non-current assets or financing should be included as appropriate.
Example 1
You are presented with the following flow forecasted cash flow data for your organisation for the period November 20X1 to June 20X2. It has been extracted from functional flow forecasts that have already been prepared.
| NovX1 | DecX1 | JanX2 | FebX2 | MarX2 | AprX2 | MayX2 | JuneX2 | |
| $ | $ | $ | $ | $ | $ | $ | $ | |
| Sales | 80,000 | 100,000 | 110,000 | 130,000 | 140,000 | 150,000 | 160,000 | 180,000 |
| Purchases | 40,000 | 60,000 | 80,000 | 90,000 | 110,000 | 130,000 | 140,000 | 150,000 |
| Wages | 10,000 | 12,000 | 16,000 | 20,000 | 24,000 | 28,000 | 32,000 | 36,000 |
| Overheads | 10,000 | 10,000 | 15,000 | 15,000 | 15,000 | 20,000 | 20,000 | 20,000 |
| Dividends | 20,000 | 40,000 | ||||||
| Capital expenditure | 30,000 | 40,000 |
You are also told the following.
(a) Sales are 40% cash 60% credit. Credit sales are paid two months after the month of sale.
(b) Purchases are paid the month following purchase.
(c) 75% of wages are paid in the current month and 25% the following month.
(d) Overheads are paid the month after they are incurred.
(e) Dividends are paid three months after they are declared.
(f) Capital expenditure is paid two months after it is incurred.
(g) The opening cash balance is $15,000.
The managing director is pleased with the above figures as they show sales will have increased by more than 100% in the period under review. In order to achieve this he has arranged a bank overdraft with a ceiling of $50,000 to accommodate the increased inventory levels and wage bill for overtime worked.
(a) Prepare a cash flow forecast for the six-month period January to June 20X2.
(b) Comment on your results in the light of the managing director’s comments and offer advice.
6.2 The Baumol model
The Baumol model is very similar to the EOQ model for managing inventory, and uses the same formula.
Suppose that a company has forecast that its cash requirement over the coming year is $1.5m and that the cash use is constant throughout the year. They have the cash available, but it is currently invested and is earning interest. To transfer the entire amount immediately would lose interest for the whole year and it would therefore be more sensible to transfer amounts throughout the year as required. However, each time cash is transferred there is a fee payable (to sell investments) and therefore the more transfers the greater the cost.
The Baumol model gives a formula for the optimum amount to be transferred each time:
Example 2
Next year a company forecasts a cash requirement of $1,500,000, the use being constant throughout the year.
The company has investments in excess of this amount which are earning 9.5% p.a..
The company earns interest of 5% on their current account bank balance.
The cost of selling investments is $150 per transaction
If the company sells $150,000 of investments each time, calculate the total cost p.a. to the company.
What is the optimal economic quantity of cash to transfer each time in order to minimise costs?
At the EOQ, what is the total cost p.a. to the company?
6.3 The Miller Orr model
The Miller Orr model does manage to achieve a reasonable degree of realism without being too elaborate.
In practice cash flows are likely to fluctuate considerably from day-to-day. There is also a likelihood that the balances are likely to ‘wander’ upwards or downwards over a period.
The Miller Orr model fixes limits on the upper and lower levels.
The basic steps involved are as follows:
A safety level or lower limit of cash is decided upon.
A statistical calculation is made based on the variations of the cash flows, in order to agree an allowable range of fluctuations.
Using this calculated range, an upper limit of cash is fixed.
The cash balance is managed to ensure that the balance is always kept between the upper and lower limits.
Miller Orr produced formulae as follows:
(these formulae are given in the examination)
The spread formula wants daily figures. Square the daily standard deviation to get the variance, and divide the annual interest rate down to a daily rate, before either goes into the formula — putting the standard deviation or the annual rate in as they stand is how this calculation is usually lost. Work those two figures out in separate steps, then the spread, then the return point.
Example 3
A company has decided it needs a minimum balance of $10,000. The transaction cost (of making transfers to/from deposit) is $5 per transaction. The standard deviation of cash flows is $2,000 per day, and the interest rate is 5.11% p.a. (or 5.11/365 = 0.014% per day)
What should be the upper and lower limits, and the return point?
Cash management
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