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Objectives
The objectives of this unit are to:
Discuss various determinants that affect and create uncertainty in the cash flows.
Explain the need for good management information system in cash management.
Structure
6.1
6.2
6.3
6.4
6.5
6.6
6.7
6.8
6.9
6.10
6.11
6.12
Introduction
Motives of holding cash
Determinants of Cash Flows
Cash Forecasting
Managing Uncertainty In Cash Flow Forecast
Managing Surplus Cash
Managing Cash-in-transit
MIS in Cash Management
Summary
Key Words
Self Assessment Questions
Further Readings
6.1
INTRODUCTION
Cash is basic input to start a business unit. Cash in initially invested in fixed
assets like plant and machinery, which enable the firm to produce products and
generate cash by selling them. Cash is also required and invested in working
capital. Investments in working capital are required because firms have to store
certain quantity of raw materials and finished goods and provide credit terms to
the customers. The cash invested in raw materials at the beginning of working
capital cycle goes through several stages (work-in-progress, finished goods and
sundry debtors) and gets released at the end of cycle to the fund fresh
investment needs of raw materials. The firm needs additional cash during its life
whenever it needs to buy more fixed assets, increase the level of operations and
any change in working capital cycle such as extending credit period to the
customers. In other words, the demand for cash is affected by several factors
and some of them are within the control of the managers and others are outside
the control of the managers. Cash management thus, in a broader sense is
managing the entire business.
In the context of working capital management, cash management refers to
optimising the benefits and costs associated with holding cash. As described
earlier, unless the cash is put into use, there is no benefit derived out just by
holding it. Further, holding cash without a purpose also costs firm either directly
in the form of interest or opportunity income that could be earned out of the
cash. At the same time, it is not possible to operate the business without holding
cash. Many of us take cash while going to office though we have bought the
tickets earlier and taking lunch with us or have a credit facility to take lunch.
Management
of Current
Though
no major
demand for cash is expected, we feel uncertain without cash.
Assets
Firms also feel uncertain without holding cash for various reasons. For instance,
any delay in collection will force the firm to delay the salary to employees or
payment to creditors or bankers which in turn affects long-term relationship with
them. Firms, which are experiencing volatile price behaviour in some of the
critical raw materials, would like to have more cash to buy the material,
whenever the price is low. There are several other motives of holding cash and
we will shortly discuss these motives in detail.
The objective of cash management is to balance the cost associated with holding
cash and benefits derived out of holding the cash. The objective is best achieved
by speeding up the working capital cycle, particularly the collection process and
investing surplus cash in short-term assets in most profitable avenues. The term
cash under cash management thus refers to both cash and credit balance in the
bank and short-term investments in marketable securities. Table 6.1 shows total
amount invested in cash and marketable securities of few industries. The figures
in the Table shows that investment in cash and marketable securities is huge and
has gone up several times in reflection to growth of operations. Investments in
cash and marketable securities also show significant differences between
industries even after taking into account the differences in the number of firms in
different industries.
Table 6.1: Investments in Cash and Marketable Securities of Manufacturing Industries
(Rupees in Crores)
Industry
1999
2000
2001
2002
2003
2306.34
2424.03
2372.82
2585.53
3014.78
Textile
2460.09
1884.74
2489.38
2506.74
2625.73
12287.85
13337.33
13618.50 17504.49
18334.49
1135.09
1369.33
1349.02
1449.67
5143.03
5188.58
6362.79
6050.11
7325.18
Machinery
8926.23
9986.02
11714.53 15334.53
18197.25
Transport Equipment
5998.40
5419.28
5744.91
5871.66
7933.06
Diversified
9852.56
9242.45
7208.94
7467.43
6849.64
721.01
1040.25
948.77
953.74
1617.11
48985.09
49657.77
51829.97 59623.25
67346.91
Chemicals
Miscellaneous
Total
Note: Figures in brackets indicate the number of companies of the industry used
to compile industry aggregates.
Thus, while structuring cash management policy, the firm has to consider the
internal business process and external environment. The important issues relating
to management of cash are:
Quantifying the cash needs of the firms to achieve the above motives; and
Activity 6.1
1) How do you relate cash management in a broader sense? What is its focus in
the context of working capital management?
.
2
Management of Inventory
.
.
.
3) Collect the cash and marketable securities data of your company or any one
company you are familiar with from published accounts for the last three or
five years. Examine the trend and its relationship with level of operation.
.
.
.
6.2
Fixed assets are used to convert the raw materials into finished goods.
Investments in current assets cannot be avoided due to constraints in technology,
manufacturing process and customers behaviour of demanding different models at
a point close to her/his house and at the point of consumption. Inventory and bills
receivables have become essential to continue business operations more fruitfully.
Emphasis is always given to reduce the investments in these assets and thus
reduce the working capital cycle. Investment in cash and marketable securities
are the least productive assets. Often, firm is not dependent on this asset in the
manufacturing process nor is required for creating inventory or selling. Thus, the
basic question is why firms hold cash and marketable securities? Some of the
reasons for holding cash are listed below.
Transaction Motive: Money is required to settle customers bills, pay salary and
wages to workers, pay duties and taxes, etc. Some cash balance is to be
maintained to complete these transactions. The amount to be maintained for the
transaction motive depends on the cash inflows and outflows. Often, firms
prepare a cash budget by incorporating the estimates of inflows and outflows to
know whether the cash balance would be adequate to meet the transactions.
Precautionary or Hedging Motive: The transaction motive takes into account
the routine cash needs of the firm. It is also based on the assumption that
inflows are as per estimation. However, the future cash needs for transaction
purposes are uncertain. The uncertainty arises on account of sudden increase in
expenditure or delay in cash collection or inability to source the materials and
other supplies on credit basis. The firm has to protect itself from such
contingencies by holding additional cash. This is called as precautionary motive of
holding cash balance. Precautionary cash balance is also maintained to meet the
non-routine needs. Generally, cash required for precautionary motive is held in the
form of short-term securities with the objective to earn atleast some positive
return. The securities are sold and cash is realised as and when such
emergency demand for cash arises.
Speculative Motive: If the firm intends to exploit the opportunities that may
arise in the future suddenly, it has to keep some cash balance. The term
speculative motive to some extent is a misnomer since cash is not kept to
conduct any speculation but merely to exploit opportunity. This is particularly
relevant in commodity sector, where the prices of material fluctuate widely in
different periods and the firm's business success depends on its the ability to
Management
of Current
source
the material
at the right time. Some of the materials, whose prices show
Assets
significant volatility, are cotton, aluminium, steel, chemicals, etc. Surplus cash is
also used for taking over of other firms. Firms that intend to take advantage on
the above counts keep large cash balances with them, though the same are not
required either for transactions or as a precaution.
Managing uneven supply and demand for cash: Firms generally experience
some seasonality in sales, which leads to excess cash flows in certain period of
the year. This is not permanent surplus and cash is required at different points
of time. One possible solution to address this mismatch of cash flows is to pay
off bank loans whenever there is excess cash and negotiate fresh loan to meet
the subsequent demands. Since firms are exposed to some amount of
uncertainty in getting the loan proposal sanctioned in time, the surplus cash is
retained and invested in short-term securities.
In a competitive environment, firms also felt the desire of holding cash to get
flexibility in meeting competition. For instance, when a competitor suddenly
resort to massive advertisement and other product promotion, it forces other firms
to increase advertisement cost or some other sales promotion such as free gift
for every purchase or lottery scheme, etc. Amount held in the form of cash and
marketable securities of twenty manufacturing companies of BSE-30 Index
(Sensex) firms has increased from Rs. 20827.76 cr. in 1999 to Rs. 20094.91 in
2003 (Table 6.2).
Table 6.2 :Investments in Cash & Marketable Securities of Manufacturing Companies in
Sensex
(Rupees in Crores)
Company
1999
2000
2001
3878.12
2223.90
1807.72
4770.76
1461.26
1326.67
1491.27
7675.29
2378.12
3341.00
191.03
2191.60
265.08
8055.17
1763.74
1479.14
383.50
407.18
3505.76
466.20
1946.49
647.86
211.10
337.31
56.48
324.96
50326.59
5525.18
9722.93
15203.81
7660.84
6247.97
8431.65
15561.74
6767.00
20213.30
2585.45
9299.45
16888.20
36959.51
12889.90
4612.13
2988.98
1047.85
4570.49
3476.45
6376.15
2389.91
1066.85
1163.95
1146.54
1865.38
2002
25706.20
4183.43
8276.70
9784.78
2658.63
2991.17
3457.94
10016.02
3873.85
2622.43
1673.09
3068.67
7994.18
6825.49
3576.49
2114.79
618.90
637.02
796.41
901.24
2538.60
1327.16
550.40
674.47
674.65
600.89
2003
2393.83
1150.11
537.43
672.22
928.75
446.21
660.62
291.52
1030.38
1623.57
37.12
877.38
1356.42
6425.93
735.70
519.87
272.15
94.55
18.10
80.06
445.73
50.41
44.01
83.56
38.28
13.85
2488.52
2331.03
2020.30
1743.80
1475.62
1217.34
1088.82
1075.50
917.38
883.78
848.84
750.64
698.41
648.33
628.80
465.55
209.07
145.88
145.42
114.13
105.80
44.70
22.92
13.58
10.75
0.00
Total
Activity 6.2
Management of Inventory
Management
Current
come
down of
significantly.
Firms following JIT, MRP, FMS, etc., could reduce the
Assets
general level of inventory and they also favourably contribute to the demand for
cash.
Activity 6.3
Management of Inventory
6.4
CASH FORECASTING
The discussion in the previous section shows various factors that affect the cash
inflows and outflows. An understanding of determinants of cash inflows and
outflows alone is not adequate in managing cash. It is necessary to forecast
cash flows using our understanding on the determinants of cash flows of the
firm. Cash forecasting is the core of cash management. A firm, which is not
forecasting the cash flows as a part of managing the cash flows, will face
unanticipated cash shortage. In order to mitigate the unanticipated cash shortage,
typically the firm will either delay the payment process or resort to emergency
borrowing. Delay in payments to suppliers will affect the price or delay in
supply, causing increased cost or expensive production delays. Emergency
borrowing will also increase the cost of borrowings. A firm with surplus cash
flow will also find it difficult to manage the cash without a forecast. Since the
information on how long the surplus cash will remain is not known, there is no
way for the firm to effectively use the cash. If short-term surplus cash is
invested for long-term, it will create unanticipated cash shortage. Surplus cash
lying within the firm will also encourage operating managers to pile up the
inventory and resort to many unproductive investments. Thus, cash forecast is
inevitable in managing the cash.
A major problem in forecasting of cash flows is that it cannot be done
independently. The determinants are many as seen in the previous section and
also highly inter-related with other budgets. Cash forecast/budget integrates
several other forecasts.
Types of Cash Forecast: The cash forecasts generated by the firms can be
broadly differentiated under two dimensions: the length of periods included within
the cash forecast and the approaches to cash flows used in the cash forecast.
Cash forecasts are normally prepared for one-year period but the forecast is
broken down to several smaller periods like, quarterly, monthly or weekly cash
7
forecasts. The choice of particular periodicity depends on the volume of cash
Management
Current
flows,
natureof of
cash flows and the desirability of the management. Firms broadly
Assets
follow two approaches in the preparation of cash forecast. Under the direct
approach, firms forecast various receipts and payments items for different periods
and consolidate the forecasts into cash budget. Under indirect approach, firms
start with forecast of earnings and then add back all non-cash expenses and
deduct all non-cash revenues, to get cash forecast. This is similar to preparation
of funds flow/cash flow statement, which is normally prepared using historical
accounting information as a part of financial statement analysis.
The format of monthly cash budget is illustrated in Table 6.3. It lists out major
cash inflow and outflow that arise in the normal operation of business. The
example also shows how the cash deficit and cash surplus are dealt with to
maintain the minimum balance.
Table 6.3 : Monthly Cash Budget
Cash Flow Item
Beginning cash balance
Collection from sales/receivables
Total
Disbursements
Suppliers
Payment of Salaries & Wages
Other Overhead Expenses
S&A Expenses
Total
Excess / -Inadequacy
Minimum Balance
Cash Available / -Needed (A)
Financing
Borrowing/ -Repayments
Fresh Equity Issue
Sell/ -Acquire Investments
Payment to Fixed Assets
Receive/ -pay interest
Dividend
Total of Financing Plan (B)
Closing Cash Balance (A - B)
January
February
March
60000
415488
475488
66078
373392
439470
61320
368280
429600
Total for
the Quarter
60000
1157160
1217160
68648
49202.4
30160
51400
199410
276078
60000
216078
60960
42150
28290
48850
180250
259220
60000
199220
56957
44670
29130
50130
180887
248713
60000
188713
186565
136022.4
87580
150380
560547
656613
60000
596613
0
0
-210000
0
0
60000
0
0
-120000
-230000
2100
0
0
30000
-230000
1800
-210000
66078
-197900
61320
3900
-250000
-188200
60513
-250000
-596100
60513
Methods of Cash Flow Forecasting: The above Table gives the output as a
result of forecasting exercise. However, each item in the above Table requires
several computations and assumptions. While a few cash flow items are
independent, several others are dependent on many other variables. Forecasting
method depends on the nature of cash flows. Some of the common methods of
forecasting are explained below:
1. Independent Cash Flow Items: These cash flow items are independent of
other factors or predetermined. Lease rent for office building, property tax,
insurance premium, etc., are few items which are determined independently.
2. Dependent Cash Flow Items: Many cash flow items are dependent on
other financial variables. For instance, cash collection from sundry debtors
depends on sales of the previous months, credit terms and collection pattern.
An understanding of the relationship between the cash flow variables is
important in forecasting the cash flows. If only one variable is associated
with cash flow items, then estimation is not difficult. On the other hand, if
several variables are associated with a cash flow item, econometric models
are used to get the value. For instance, if customers take more than two
8
Inventory
months credit period to pay the amount, it is possible toManagement
construct a ofmultiple
regression model to measure the proportion of amount collected from various
months sales. The model uses cash collection of the month as dependent
variable and previous months sales values as independent variables.
3. Growth in Cash Flow Items: As business grows, the cash flow items also
see a positive growth. Suppose the total sales grow at five percent every
quarter and credit (60 days) sales is eighty percent of the sales. If forty
percent of the customers pay at the end of two months in time, another 40
percent pays at the end of three months and the balance 20 percent pays at
the end of fourth month the amount collected from the customers is also
expected to show an uptrend due to growth in sales.
The most usual approach to cash forecasting is the Receipts and Payments methods
as accepted in Table-6.3. After the firm has determined what types of receipts and
payments are important in its overall cash flow, an important question is how to
forecast the future level of inflows and outflows. There are four common techniques
of forecasting these items of receipt and payment.
a) Direct Method In using this technique, it is assumed that the variable to be
forecast is independent of all other variables, or alternatively, is predetermined.
The variables (e.g.lease rental) is forecast by using its expected or
predetermined level.
b) Proportion of Another Account This technique is used to project financial
variables that are expected to vary directly with the level of another variable. For
example, if sales volume increases, it is natural that more units will have to be
produced to replenish inventory. It is then reasonable to project certain direct
costs of production, such as direct materials, as a per cent of sales.
c) Compounded Growth This method is used when a particular financial
variable is expected to grow at a steady growth rate over time. The formula used
is:
Yt = (1 + g) Y t-1
Where Yt-1 is the prior periods level of y and g is the growth rate.
d) Multiple Dependencies : Under this technique the variable is considered to be
influenced by more than one factor. The statistical technique of linear
regression is often employed with historical data to determine which
explanatory variables are significant in explaining the dependent variable.
We will see the application of regression technique after a while.
Since cash forecasts deal mostly with the near future, many of the items on the cash
forecast are usually estimated by some variation of the spot method. The bases of
these spot estimates are usually the firms other financial plans. Remaining estimates
are mostly on a proportion of another account basis, the another account often being
a particular periods sales. The other two methods are employed less frequently.
It is a common experience that forecast of disbursements is much easier than
receipts, because the cash manager can rely on internal information and knowledge
of payment policy in order to determine what needs to be paid and when. Besides, he
has the knowledge of firms other plans (or budgets) and can make use of the
forecasting techniques described above. However, a major challenge for him comes
in estimating the receipts from the collection of the firms receivables. In this
regard, an useful forecasting method is to analyse the historical payment patterns to
determine the proportion of credit sales that are collected at various times after the
date of sale, and then to use this information (along with the estimates of future sales)
to project future receipts. This has been illustrated in the unit 14 of MS-4 (under the 9
Management
of Current
head
Sales Work
Sheet). We may, however, adopt a better and a more sophisticated
Assets
approach. In this all collection rates are estimated simultaneously by regressing past
sales figures against past collections. The estimated coefficients of the sales figures
in the regression can be interpreted as the collection proportions, and the standard
errors of the estimated regression coefficients as the uncertainty inherent in the
estimation of these collection proportions.
Let us take an example. Suppose that a firm has regressed its monthly collections for
past months against the appropriate past monthly sales figures and has obtained the
following results:
Ct =
0.754 St 1 + 0.241St 2
(0.250) (0.087)
The figures in parentheses below the estimated collection rates are the standard
errors of these collection rates. In this equation, Ct is the collection from receivable in
period t, St 1 is the sales in period t 1 (say, previous month), and St 2 is the sales in
period t-2 (say, two months previously). Assume also that these were the only
statistically significant explanatory variables (the variables like St 3, St 4, etc. and
dummy variables to assess seasonality, were not significant), and that the overall
estimated equation was highly significant. We may now interpret the regression
results in the following way. The estimated collection rates are 75.4 per cent
(regression coefficient on St 1) of the previous months sales and 24.1 per cent
(regression coefficient on St 2) of the sales from two months previously. The implied
bad debt rate is 0.5 per cent, equal to one minus the sum of the collection rates. The
standard error figures are used to test the statistical significance of the estimated
regression coefficients.
Simulation Approach
Simulation analysis permits the financial manager to incorporate in his forecasting
both most likely value of ending cash balances (surplus/deficits) for each of the
forecast periods (say, for each month over the next quarter) and the margin of error
assoicated with this estimate. It involves the following steps: First, probability
distributions for each of the major uncertain variables are developed. The variables
would generally include sales, selling price, proportion of cash and credit sales,
collection rates, production costs, and capital expenditures. Some of these variables
have the greatest influence upon cash balances. Clearly, more time and effort should
be spent in obtaining probability distributions of these variables. Second, values are
drawn at random for the variables from their respective probability distributions, and
using these values each balances are estimated. Third, the process is repeated
several times (say, 100 times). Needless to say, such tedious and cumbersome
computations are done on computer. From the trial results, information of the kind as
shown in table 6.4 would be generated.
Table 6.4 : Hypothetical Simulation Results
10
Month
Standard Deviation
(Rs. in '000)
April
3,104
334
May
1,258
375
June
-1,221
353
July
-1,104
402
August
-363
403
September
591
421
Management
of Inventory
How can the finance manager use the results of the simulation?
The usefulness
of
the results as shown in Table 6.4 lies in the fact that summary statistics (i.e. average
cash balances and standard deviation) can be used to determine upper/lower
estimates of cash surplus or deflcit for each month, with a probability of say 95
per cent that cash balance will remain within the estimated range. Assuming that the
distribution of month-ending cash balances is normal, we can obtain the upper/lower
estimates by applying the following formula.
Upper/Lower Estimates
= Average Cash Balance + Z Standard Deviation
where Z is the standard normal variate.
With the information of this type in hand, finance manager can now address the
formulation of appropriate investement and financing strategies. Let us now proceed
with some examples to illustrate the point.
Consider our hypothetical simulation results and assume that the costs of having
insufficient cash and the costs of hedges (i.e. financial arrangement to fall back upon
in case of shortage of cash) are such that the firm desires to incur, at maximum, a 5
per cent chance of having insufficient cash to cover expenses. What is the maximum
amount for which the firm should secure a line of credit? The maximum expected
deficit is in the month of June, with a mean of Rs. 12,21,000 and a standard deviation
of Rs. 3,53,000. The Z statistic for 95 per cent confidence interval is 1.645; and 1.645
times of Rs. 3,53,000 is Rs.5,80,685. The maximum amount that the firm should
arrange to borrow is Rs. 12,21,000 plus. Rs. 5,80,685 or Rs. 18,01,685. There is a 5
per cent chance that the actual borrowing needs in June will be greater than this and
a 95 per cent chance that the requirements will be less than this.
Let us now consider that the firm is contemplating how much of the estimated surplus
in September to invest in a 60-day investment. How much can the firm invest and
have only 10 per cent chance of having to resell the investment in September? Z
statistic for 90 per cent confidence interval is 1.28; times of Rs. 4,21,000 is
Rs.5,38,880; Rs. 5,91,000 less Rs. 5,38,880 is Rs.52,120. There is 10 per cent chance
that cash surplus in September will be less than Rs. 52,120. So, the firm can invest
the amount in the 60-days investment and have a 10 per cent chance that they will
have to liquidate the investment prior to maturity.
The above exmaples are intended to illustrate the mechanics of manipulating means,
standard deviations, and probabilites of cash balances rather than to present realistic
hedging strategies. In practice, the array of possible hedging strategies is quite a bit
more complicated. One is required to consider various alternatives and the assoicated
costs and risk in hedging strategies.
Activity 6.4
1) Why do we need to forecast cash flows while managing the cash?
.
.
.
.
.
11
Management
of Current
2)
Collect cash
flow statement given in the annual report of a large listed
Assets
company for the last five years. Comment on the trend in the component.
.
.
..
..
..
3) How does simulation approach help in cash forecasting?
.
.
..
..
Management
of Inventory
to define the distribution of cash flow forecast and uncertainty
associated
with
the forecast.This is discussed in more detail in the previous section.
13
Management
some
delay of
in Current
getting long-term funds. The situation is set right once the firm
Assets
receives the long-term funds. In other words, profit-making firms periodically
generate cash surplus even though they face pressure on cash flows in other
times. The issue is how to deal with such surplus cash. Excess cash balance is
the least productive asset of the firm and thus should be minimised.
Management
Inventory
agree to the proposal since they loose the float Thus, we need
to look of
into
our
collection system for improvement.
Management
of Current
that
the collection
process in the near future will be fully automatic, as far as the
Assets
banking operations are concerned.
Activity 6.6
1) Why is it important to manage the cash-in-transit?
.
.
.
2) What are different options available before the firm in improving collection
efficiency of cash-in-transit?
.
.
.
3) Draw an activity chart that speeds up the process of depositing the cheque in
the bank account from the time of receipt?
.
.
.
4) Outline the impact of internet banking on corporate cash menagement.
.
.
.
Management
of Inventory
actions are possible by developing a good reporting system that
highlights
such
deviations without loss of time.
The daily cash report is the best vehicle for obtaining a running comparison
between the forecast and actual cash flows. Daily cash reporting is useful even
if cash budget and forecast are not available on daily basis. It helps the
managers to understand the flow of cash on daily basis and a comparison of
cumulative figures with the budget indicates the target still to be achieved to keep
the budget in force. In addition, the reporting on daily basis to top management
forces the operating people to work efficiently. This is very useful since
accounting profit cannot be computed on daily basis and available only at the end
of quarter.
Meaningful analysis can be done by consolidating cash flows on daily basis into
two documents namely Cash Flow Budget-Actual Variance Analysis and
Cumulative Cash Flow Statement for the year to date. The formats for the two
reporting documents are given below.
Table 6.5 : Cash Flow Budget-Actual Variance Analysis from .. to .
Cash Flow Item
Budget
Actual
Variance
Remarks
17
Management of Current
Assets
Budget for
the Year
Performance
till Date
Target for
the Remaining
Period
A variety of cash reports designed for specific needs of individual companies are
in vogue for checking cash flows and ensuring constant availability of adequate
cash. For example, if the firm has only a few large customers, the top
management would like to have customer-wise cash collection reporting to speed
up the process of collection at the highest level. The information collected from
these statements is useful to fix responsible centres for variance and initiate
corrective steps, which are essential steps in control exercise. The corrective
steps include short-term efforts such as speeding up the collections by chasing a
few large customers and long-term policy changes such as revising credit period
or credit-granting decision.
6.9 SUMMARY
Availability of cash is crucial for the operation of business. However, cash is the
least productive asset of the firm and thus managers take every effort to
minimise the cash holding. Despite the least productive nature of the asset, firms
hold large cash. There are several motives behind holding cash. Cash is required
to settle dues of the firm. Since cash inflows are uncertain and outflows are
certain, firms keep additional cash. Cash kept for these two purposes are called
transaction motive and precautionary motive. Cash is also kept to overcome the
mismatch of inflows and outflows, cyclical behaviour of cash flow pattern and
exploit short-term opportunities, like rising prices and aquisition of control.
Cash flows are affected by internal factors such as operating and financial
policies and external factors such as monetary and fiscal policies and practices of
industry. An understanding on factors that affect the cash flows is useful to
forecast future cash flows, which is core aspect of cash management. There are
several methods of forecasting cash flows and often different methods are
employed
to forecast individual cash flow items. Cash forecasting is converted
18
Inventory
into cash budgets and cash budget is broken into quarterly, Management
monthly andofweekly
cash budgets. Budgets are prepared to understand whether cash inflows and
outflows match with each other and if not, to know the period in which the
mismatch arises. Managers plan to deal with such mismatches by initiating action
in advance.
Despite careful planning, actual cash flows often deviate from the budgets due to
inherent uncertainty associated with cash flow variables. There are several tools
such as sensitivity analysis, simulation, etc., available to evaluate the impact of
uncertainty on cash flows. The uncertainty associated with the cash flows is
managed by holding additional cash, negotiating stand-by borrowing facility and
interest rate derivatives. Management of cash includes dealing with surplus cash
and cash-in-transit. While surplus cash is to be invested in short-term securities
after conducting cost-benefit analysis, cash-in-transit are managed by taking
efforts to reduce the float and float amount.
While planning and decision-making are essential for any management system, the
system completes only when appropriate control mechanism is built into the
system. Management information system assumes importance in this context in
cash management system. Periodical reporting on cash flows and variance
analysis of such flows is essential to effectively manage the cash flows. The
objective of the entire exercise is to ensure availability of cash to conduct smooth
business and at the same time to minimise the investments in this least productive
asset.
Management of Current
Assets
6.11
SELF-ASSESSMENT QUESTIONS
1. Explain the objective of cash management system. How do you deal with
the conflicting nature of the objectives?
2. What are the principal motives of holding cash in a business despite its
unproductive nature?
3. Discuss internal and external determinants that affect the flow of cash.
4. Why is it important to forecast the cash flows in managing the cash?
5. How do you measure the uncertainty associated with cash flows? Discuss
the products available to manage the uncertainty of cash flows?
6. What is flotation? How do you cut down the flotation time?
7. Discuss the importance of cash flow reporting in the management of cash?
8. Digital Electronics Ltd. is preparing cash budget for the next quarter in order
to negotiate with the bankers for additional credit. The sales department
informs that March sales was Rs. 220 lakhs and the expected sales for the
next four months are Rs. 120 lakhs, Rs. 160 lakhs, Rs. 220 lakhs and Rs.
160 lakhs respectively. The company sells 30% of sales through cash and
the balance on credit basis with one month as credit period. The bad debts
level is negligible. Cash outflows consist of payment to creditors, salary and
wages, other operating expenses, purchase of fixed assets and taxes. The
material and labour costs constitute 30% and 45% respectively of the sales.
While raw materials are purchased in one-month credit, wages are paid in
the same month. Other operating expenses cost Rs.50 lakhs and are paid in
the same month. Other non-operating cash flow items are Rs. 150 lakhs in
May (fixed assets), Rs. 120 lakhs in June (fixed assets), Rs. 160 lakhs in
June (corporate tax) Rs. 140 lakhs in April (interest and instalment of loan)
and Rs. 100 lakhs in May (dividend). The cash at the beginning of the
quarter was Rs. 150 lakhs and the companys cash policy is to hold 5% of
total cash expenses of the next month as minimum closing balance of the
current month. Prepare a monthly cash flow statement for the quarter and
highlight the surplus/deficit for each month.
9.
20
Kidcat is a leading manufacturer of toys and sports items for kids. The
industry is facing severe competition from unorganised sector, which imitate
the Kidcat products immediately. The sales of the firm during the last two
years show significant volatility. The firm decides to use simulation this time
while preparing cash budget. The firm has sold Rs. 100 lakhs worth of toys
during the month of March and expects the following possible ranges of sales
between April to June of the next year.
Sales (Rs. in lakhs)
40
80
120
160
Probability
20%
30%
30%
20%
The customers generally pay within a month of sales. The material cost
associated with the product works out to 40%, which are paid after a month
and fixed cost including labour cost of the firm per month is Rs. 30 lakhs.
Fixed costs are paid in the same month. Conduct a simulation exercise of
100 trails using random numbers and find the cash balance at the end of
each month and their distribution. (Hint: Use of Spreadsheet is recommended
to conduct simulation exercise).
Management ofcompany
Inventory
10. The internal analysis of cash flows of a large textile manufacturing
shows a wide variation in cash balances during the next year. The minimum
cash balance expected during the second quarter of the year was -Rs. 340
lakhs (negative balance indicating shortage of cash) and the maximum value
of Rs. 120 lakhs during the month of February. The above figures are
estimates and likely to see significant volatility. The firm presently enjoys over
draft limit of Rs. 300 lakhs and contemplating to increase the limit to Rs. 400
lakhs to meet the additional cash need and also uncertainty associated with
cash flows. The bank is willing to provide the additional loan at 14% interest
rate but insists the firm to accept a commitment charge of 0.25% per month
on the additional borrowing limit. The commitment charge has to be paid on
unused part of the overdraft facility. For instance, if a firm draws Rs. 340
lakhs in August, it has to pay interest at the rate of 14% on Rs. 340 lakhs
and 0.25% on Rs. 60 lakhs. If the firm decides not to accept the offer, it
will be exposed to cash out position and emergency borrowing would cost
2% interest per month. The firm expects a maximum emergency borrowing
of Rs. 200 lakhs at different points of time during the year. Advice the firm
on accepting the additional loan with a commitment charge of 0.25%.
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