Chapter 10 – Cash Management

Chapter agenda
Reasons for holding cash

Consequences of poor
cash management

Cash forecasts Vs Cash Receipts & payments

budgets forecast

Preparing cash forecasts Balance sheet forecast

Cash managment
Working capital ratios

Baumol
Cash management
models
Miller - Orr
Short term investments
and borrowings

Funding working capital

Introduction – Cash management

Companies must maintain the right amount of cash in hand as it affects the company’s
liquidity and profitability aspects.

Liquidity – Having cash in hand improves the ability to meet expenses and take advantage
of market investment opportunities

Profitability – Having cash in hand in excess can lead to loss of interest income that could
have been earned had they were deposited/invested

Why do companies hold cash?

There are many reasons as to why companies hold cash in hand. They can be categorised
under 3 headings.

 For transaction purposes – To meet day-to-day expenses

 Speculative purpose – To take advantage of market opportunities that arise
 Precautionary purpose – To meet unplanned unexpected expenses

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What are the consequences of poor cash management?
Cash is said to be the life blood of a business.

Poor cash management is typically referred to a situation where companies failing to settle
debts as they become due.

Some consequences of poor cash management are

 Loss of settlement discounts

 Loss of supplier good-will
 Liquidation

Cash forecasts Vs cash budgets

Cash forecast – A forecast of cash inflows and outflows for a future period

Cash budget – A plan for cash inflows and outflows for a future period after considering
actions required to bring the forecast in line with the business plan.

Cash budgets is a critical aspect of budgeting that is used to

1. Evaluate and integrate operating budgets

2. Plan for cash deficits and surpluses
3. Compare actual spending

How to prepare a cash forecast?

There are 3 methods

1. Using receipts and payments forecasts

2. Using balance sheet forecasts
3. Using working capital ratios

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 1. Receipts and payments forecasts
This is a forecast of cash receipts and payments based on anticipated sales, cost of sales and
timings of cash flows.

Sources of cash receipts are typically cash sales, payments by customers for credit sales,
proceeds from sales of PPE, receipt of interest and dividends, issue of loans etc,

Not all receipts are income statement items.

Cash payments are typically, Purchase of inventories, purchase of capital items, payroll costs
or other expenses.

Not all payments are income statement items.

In the exam, the following steps should be adopted to show the forecast.

Step 1 – Prepare the proforma

Month 1 2 3 4
$ $ $ $
Receipts (Underneath, show all receipts)
Sub total X X X X

Payments (Underneath show all payments)

Sub total X X X X

Net cash flow X X X X

Opening balance X X X X
Closing balance X X X X

Step 2 – Include the simple figures into the proforma

Calculating salaries and wages, fixed costs, dividend payment will be easy thus less time
consuming

Step 3 – Do the workings for complex figures

More time is required to work out sales & purchases as, timings of sales receipts and
payments to suppliers will be based on credit periods. In addition expenses variable
overheads & purchases depend on production levels & inventory levels.

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Example – Receipts and payments forecast

In the next month, a company will purchase assets worth of $630,000. This includes
equipment and fittings of ($240,000). A delivery vehicle is purchased for $60,000 and is paid
for in the second month of operations.

The following forecasts have been made

Sales of the business’s single product, at a mark-up of 50% on production cost will be:

Month 1 2 3 4 5 6
($000) 216 216 234 216 270 288

60% of sales will be for cash & the remainder will be on credit – settled one month in
arrears

Production cost will be $12 per unit. The production cost will be made up of:

Raw materials (cost per unit) $7.00

Direct labour (cost per unit) $3.00
Fixed overhead (cost per unit) $2.00

Production is arranged in such a way that closing inventory at the end of any month is equal
to sales units of the following month. Opening finished goods inventory is valued at $60,000
& opening inventory units is 10000

Only one type of raw material is used in the production. It is purchased in such a manner
that inventory at the end of a month is equal to the half of the following month’s production
units. Opening raw material inventory is $30,000 and there are 15000 units in it. Raw
materials are purchased on one month’s credit. (Assume two units of raw material is
required to produce one unit of FG)

Direct labour costs will be met in the month it is incurred

The fixed production overhead rate of $2.00 per unit. This has been calculated based on a
forecast of the first year’s production of 200,000 units. This rate includes depreciation of
equipment and fittings on a straight line basis over the next 4 years. Fixed production
overhead is paid in the month incurred.

Selling and administration overheads are all fixed, and will be $300,000 in the first year.
These overheads include depreciation of the delivery van at 30% per year straight line basis.
All fixed overheads will be incurred on a regular basis, and paid in the month incurred.

Required:
(a) Prepare a monthly cash flow forecast. You should include the business purchase and the
first four months of operations following purchase.

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 2. Balance sheet forecasts
This involves preparing a cashflow forecast from a statement of financial position.
In that following forecasts are required to find the cash balance at the end of a specific
period

 changes to NCA due to acquisitions and disposals

 future inventory levels
 future receivables levels
 future payables levels
 changes to share capital and other long-term funding (e.g. bank loans)
 changes to retained profits

Example – Balance sheet forecasts

Statement of financial position of ABC company as at 30 June 2019 is given below

$ $
NCA
PPE 192,000
Current assets
Inventory 16,000
Receivables 80,000
Bank 2,000
98,000
Total assets 290,000

Equity & liabilities

Share capital 216,000
Retained profits 34,000
250,000
Current liabilities
Payables 10,000
Dividend payable 30,000
40,000
Total equity and liabilities 290,000

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The company expects to acquire further plant and machinery costing $8,000 during the year
to 30 June 2020.

The levels of inventories and receivables are expected to increase by 5% and 10%
respectively by 30 June 2020, due to business growth.

Trade payables and dividend liabilities are expected to be the same at 30 June 2020.

No share issue is planned, and retained profits for the year to 30 June 2020 are expected to
be $42,000.

Plant and machinery is depreciated on a reducing balance basis, at the rate of 20% per year,
for all assets held at the statement of financial position date.

Required:

Produce a financial position statement forecast as at 30 June 2020, and predict what the
cash balance or bank overdraft will be at that date.

3. Working capital ratios

Working capital ratios can be used in forecasting

In that, working capital ratios must be calculated firstly to determine the working capital
requirement.

The following proforma must be used in answering exam questions

Operating profit X
Add: Depreciation X
––––
Cash flow from operations X
Add: Cash from sale of non-current assets X
Long-term finance raised X
Less: Purchase of non-current assets (X)
Redemption of long-term funds (X)
Interest paid (X)
Tax paid (X)
Dividend paid (X)
Increase in working capital (X)
––––
Net cash flow X

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Example – Working capital ratios

Consider the financial information of XYZ Company below.

Statement of profit and loss (Extracts)

Sales 400
Cost of sales 200
GP 200
Depreciation (40)
Operating profit 160
Interest (10)
PBT 150
Tax (44)
PAT 106
Dividends proposed 20
Retained earnings 86

Statement of financial position (Extracts)

NCA 960
Current assets
Inventory 50
Receivables 66
Cash 80
196

Current liabilities
Trade payables 40
Dividend payable 20
Tax payable 44
104
Long term liabilities (10%) 100

XYZ expects the following for the next year.

Sales will increase by 10%
Purchases of Plant $12m
Inventory days 80 days
Receivables days 75 days
Trade payables days 50 days
Depreciation will be $15m

Required:
Prepare a cash flow projection for the forthcoming period

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What are cash management models?
Cash management models are used to minimise the total costs related to movements
between the current account & short-term investments.

It should be noted that a current account is highly liquid but attracts zero interest income
whilst short-term investments may not be liquid but attracts interest income

There are two main models

1. The Baumol model

2. The Miller-Orr model

Baumol model
Model argument – The cash balance held in non-interest-bearing current accounts should
be low when interest rates are high

Model equation
2𝐶𝑂 𝐷
𝑄 =√
𝐶𝐻

whereas
Q – Funds transferred to the current account or short-term investments at one time
CO – Transaction costs (Commission, brokerage etc)
D – Demand for cash
CH Cost of holding cash

Model assumptions

 Cash usage is predictable

 cash inflows are known and regular
 day-to-day cash payments are met from current account
 Buffer cash is held in short-term investments

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Example - Baumol

A company has excess cash of $20,000 per month. Company is planning to invest this in
short-term securities. The interest rate on its investment is 10% per annum. The transaction
costs associated with each separate investment of funds is constant at $100.

Required:

a) What is the optimum amount of cash to be invested in each transaction?

b) How many transactions will arise each year?
c) What is the cost of making those transactions per year?
d) What is the opportunity cost of holding cash per year?

The Miller – Orr model

Model arguments
Irregular movements of cash is controlled by setting upper & lower control limits on cash
balances.

Used to set the target cash balance.

In this model, uncertainty is incorporated into the cash flows. Thus more realistic than
Baumol model.

Model equations

𝑈𝑝𝑝𝑒𝑟 𝑙𝑖𝑚𝑖𝑡 = 𝐿𝑜𝑤𝑒𝑟 𝑙𝑖𝑚𝑖𝑡 + 𝑆𝑝𝑟𝑒𝑎𝑑

1
𝑅𝑒𝑡𝑢𝑟𝑛 𝑝𝑜𝑖𝑛𝑡 = 𝐿𝑜𝑤𝑒𝑟 𝑙𝑖𝑚𝑖𝑡 + 𝑥 𝑠𝑝𝑟𝑒𝑎𝑑
3
1
0.75 𝑥 𝑇𝑟𝑎𝑛𝑠𝑎𝑐𝑡𝑖𝑜𝑛 𝑐𝑜𝑠𝑡 𝑥 𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠) 3
𝑆𝑝𝑟𝑒𝑎𝑑 = 3 𝑥 ( )
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒

Interest rate and variance must be stated in daily terms

If the standard deviation of cash flows is provided, get the squared term to obtain the
variance

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Model graph

H – Higher limit
L – Lower limit
Z – Target cash balance

L is set by the firm. It depends on how much risk of a cash shortfall the firm is willing to
accept.

H is derived through the model.

If the cash balance reaches L, then it must be replenished back to Z through means such as a
sales of a short term investment/cashing out a deposit

If the cash balance reaches H, then it must be invested in a short term investment/deposit
account so that cash balance comes down to Z

(The point is cash balance must be at Z)

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Example - Miller-Orr

The minimum cash balance of $30,000 is required at ABC. Transferring money to or from the
bank costs $50 per transaction. Inspection of daily cash flows over the past year suggests
that the standard deviation is $3,000 per day, and hence the variance is $9 million. The
interest rate is 0.03% per day.
Calculate:

a) The spread between the upper and lower limits

b) The upper limit
c) The return point

What are Short term investments?

When there are temporary cash surpluses, businesses invest them in short term
investments such as money market deposits.

Selection of an appropriate short term investment requires the business to consider 3

conflicting objectives.

 Profitability: Investment must earn the highest possible after-tax returns

 Liquidity: Investment must be liquid
 Safety: Investment must be free of risk of loss

Factors to be considered under each objective

Profitability Liquidity Safety

Fixed or variable interest Penalties on early Risk of losing the capital
rate income withdrawals value

Time to maturity Bridging finance to cover Risk of investing in other

gap between time when currencies
cash is needed and maturity
of investment
Tax on income Future interest rate
movement
Ability to invest in a
different currency

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What are short term borrowings?
When there are temporary short falls of cash they can be funded through bank overdrafts
and bank loans. ODs are considered to be most importance source of short term finance

ODs Loans
Ability to make payments using the current Formal agreement
account even when funds are insufficient Bank lends an amount for a period
(Max limit is imposed) Client makes interest and principle
payment
Highly flexible necessary (Limit can be Rigidity (Once borrowed, loan value cannot
increased) be increased)
Low cost (Interest payable on funds High cost (Higher interest charge)
borrowed)

How to fund working capital?

This involves identifying the most appropriate source of financing that must be used to fund
working capital requirements.

There are long term & short term financing methods.

The decision on long term or short term financing depends on factors such as

a) The extent to which current assets are permanent or fluctuating

b) Cost of financing method
c) Risk attitude of managers

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What is permanent and fluctuating current assets?
Some proportion of current assets are fixed in most businesses. These are typically,

1. Minimum cash balances

2. Buffer inventory
3. Receivables during the credit period

Financing these fixed current assets requires undertaking a cost-risk analysis of short term
finance

Costs Risks
Cost is lower compared to long term Must be renegotiated and renewed once
finance due to short time period they mature
Short term finance is flexible (OD can be Interest rate uncertainty at renewal
used to fund fluctuating current assets
when necessary)
Short term finance is tax deductible

What is the difference between working capital investment level &

working capital financing?
Working capital investment level refers to the investment in current assets. This is often
compared to that of another company.

Working capital financing refers to the proportions of short term and long-term financing
used by the company. This involves analysis of financial information of just one business.

In the exam, you should not discuss the liquidity and profitability concepts if the question
is on working capital financing.

A business’s working capital investment level can be aggressive (low investment in CA – Low
current ratio) or conservative (high investment in CA – High current ratio)

Working capital financing policies depend on the risk attitude of managers of the business.

This is the most important factor that influences working capital funding decisions.

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 Aggressive Conservative

Use of short term financing to fund CA thus Use of long term financing to fund CA thus
high risk undertaking low risk undertaking

Low cost of funding (Low interest) High cost of funding (High interest)

Sometimes the duration of working capital investment and financing are matched.

Final considerations in working on capital funding

In addition to the factors discussed above, the following must also be considered when
selecting the type of funding.

Size of the business – Small firms may opt for short term financing

Industry-wide risks – If the industry has volatile earnings, then a conservative approach may
be more suitable.

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