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8. CASH MANAGEMENT

INTRODUCTION

 

Cash management is one of the key areas of working capital management. 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 liquid assets, that is; receivables and inventory get eventually converted into cash. This underlines the significance of cash management.

 

OBJECTIVES OF CASH MANAGEMENT

 

The basic objectives of cash management are two-fold:

(a)    to meet the cash disbursement needs (payment schedule); and

(b)    (b) to maintain minimum cash reserve

 

These are conflicting and mutually contradictory and the task of cash management is to reconcile them.

 

MEETING PAYMENTS SCHEDULE

 

In the normal course of business, firms have to make payments of cash on a continuous and regular basis to suppliers of goods, employees and so on. At the same time, there is a constant inflow of cash through collections from debtors. Cash is, therefore, aptly described as the ‘oil to lubricate the ever-timing wheels of business: without it the process grinds to a stop. A basic objective of cash management to meet the payment schedule, that is, to have sufficient cash to meet the cash disbursement needs of a firm.

 

The importance of sufficient cash to meet the payment schedule can only be overemphasized. The advantage of adequate cash are:

(i)                  it prevents insolvency or bankruptcy arising out of the inability of a firm to meet its obligations;

(ii)                the relationship with the bank is not strained;

(iii)               it helps in fostering good relations with trade creditors and suppliers of raw materials, as prompt payment may help their own cash management;

(iv)              a cash discount can be availed of if payment is made within the due date for example, a firm is entitled to a 2 per cent discount for a payment made within 30 days. Since the net amount is due in 30 days, failure to take the discount means paying an extra 2 per cent for using the money for an additional 20 days. If a firm were to pay 2 per cent for every 20-day period over a year, there would be 18 such periods (360 days ¸ 20 days). This represents an annual interest rate of 36 per cent;

(v)                it leads to a strong credit rating which enables the firm to purchase goods on favorable terms and to maintain its line of credit with banks and other sources of credit

(vi)              to take advantage of favorable business opportunities that may be available periodically; and finally

(vii)             the firm can meet anticipated cash expenditure with a minimum of strain during emergencies, such a strikes, fires or a new marketing campaign by competitors. Keeping large cash balances, however, implies a high cost. The advantage of prompt payment of cash can well be realized by sufficient and not excessive cash.

 

To maintain minimum cash reserve: Another important objective of cash management is to maintain minimum reserve. This means in the process of meeting obligations on time, the firm should not unnecessarily maintain heavy cash reserves. It cannot keep the can idle. Excess cash balances should be made productive (this means it should be invested). Maintaining minimum cash reserve is made budgeting. Cash collection should be expedited and cash outflows should be controlled to conserve cash resources. Thus as far as possible the firm should maintain minimum cash reserves to attain the objective of profitability.

 

CASH MANAGEMENT TECHNIQUES

 

Managing cash collections and receivables to enhance the efficiency of cash management, collections and disbursements must be properly monitored. There are some specific techniques and processes for speedy collection of receivables from customers and slowing disbursements. We discus them in the present section. In this respect the following are helpful.

 

Speedy Cash Collection

           

In managing cash efficiently, the cash inflows process can be accelerated through systematic planning and refined techniques. There are two broad approaches to do this. In the first place, the customers should be converted into cash without any delay.

 

a)      Prompt Payment by Customers One-Way to ensure prompt payment by customers is prompt billing. What the customer has to pay and the period of payment should be notified accurately and in advance. The use of mechanical devices for billing along with the enclosure of a self-addressed return envelope will speed up payment by customers. Another, and more important, technique to encourage prompt payment by customers, is the practice of offering cash discounts. The availability of discount implies considerable saving to the customers. To avail of the facility, the customers would be eager to make payment early.

 

b)      Early Conversion of Payments into Cash Once the customer makes the payment by writing a cheque in favor of the firm, the collection can be expedited by prompt encashment of the cheque. There is a lag between the time a cheque is prepared and mailed by the customer and the time the funds are included in the cash reservoir of the firm. Within this time interval three steps are involved:    

(a)                           transit or mailing time, that is, the time taken by the post offices to transfer the cheque from the customers to the firm. This delay or lag is referred to as postal float;

(b)                          time taken in processing the cheques within the firm before they are deposited in the banks, termed as lethargy; and

(c)                           collection time within the bank, that is, the time taken by the bank in collecting the payment from the customer’s bank. This is called bank float. The term deposit float is defined as the sum of cheques written by customers that are not yet usable by the firm.

 

The collection of accounts receivable can be considerably accelerated, by reducing transit, processing and collection time. An important cash management technique is reduction in deposit float. This is possible if a firm adopts a policy of decremented collections.

Some of the important processes that ensure decentralized collection so as to reduce

(i)      the amount of time that elapses between the mailing of a payment by a customer, and

(j)     the point the funds become available to the firm for use.

 

 The principal methods of establishing a decentralized collection network are

(a)    Concentration Banking, and

(b)   Lock-box System.

     

Concentration Banking In this system of decentralized collection of accounts receivable, large firms, which have a large number of branches at different places, select some of the strategically located branches as collection centers for receiving centers for customers. Instead of all the payments being collected at the head office of the firm, the cheques for a certain geographical area are collected at a specified local collection center. Under this arrangement, the customers are required to send their payments (cheques) to the collection center covering the area in which they live and these are deposited in the local account of the concerned collection center, after meeting local expenses, if any. Funds beyond a predetermined minimum are transferred daily to a central or distributing bank or account. A concentration bank is one in which the firm has a major account-usually a disbursement account. Hence, this arrangement is referred to as concentration banking.

     

Concentration banking, as a system of decentralized billing and multiple collection points, is a useful technique to expedite the collection of accounts receivable. It reduces the time needed in the collection process by reducing the mailing time. Since the collection centers are near the customers, the time involved in sending the bill to the customer is reduced. Moreover, the time lag between the dispatch of the cheque by the customer and its receipt by the firm is also reduced. Mailing time is saved both in respect of sending the bill to the customers as well as in the receipt of payment. The second reason why concentration banking reduces deposit float is that the bank of the firm as well as the customers may be in close proximity. Thus, the arrangement of multiple collection centers with concentration banking results in a saving of time in both mailing and clearance of customer payments and leads to a reduction in the operating cash requirements. Another advantage is that concentration permits the firm to ‘store’ its cash more efficiently. This is so mainly because by pooling funds disbursement in a single account, the aggregate requirements for cash balance is lower than it would be if balances are maintained at each branch office.

 

Lock-Box System The concentration banking arrangement is instrumental in reducing the time involved in mailing and collection. But with this system of collection of accounts receivable, processing for purpose of internal accounting is involved, that is, some time elapses before a cheque is deposited by the local collection center in its account. The lock-box system takes care of this kind of problem, apart from affecting economy in mailing and clearance times. Under this arrangement, firms hire a post office lock-box at important collection centers. The customers are required remit payments to the post office lock-box. The local banks of the firm, at the respective places, are authorized to open the box and pick up the remittances (cheques) received form the customer. Usually, the authorized banks pick up the cheques several times a day and deposit them in the firm’s accounts. After crediting the account of the firm, the banks send a deposit slip along with the list of payments and other enclosures, if any, to the firm by way of proof and record of the collection.

 

Thus, the lock-box system is like concentration banking in that the collation is decentralized and is done at the branch level. But they differ in one very important respect. While the customer sends the cheques, under the concentration banking arrangement, to the collection centers, he sends them to a post office box under the lock-box system. The cheques are directly received by the bank, which empties the box, and not from the firm or its local branch.

 

In a way, the lock-box arrangement is an improvement over the concentration banking system. Its supervisory arises from the fact that one step in the collection process is eliminated with the use of lock-box: the receipt and deposit of cheques by the firm. In other words, the processing time within the firm before depositing a cheque in the bank is eliminated. Also some extra saving in mailing timing is provided by the lock-box system, as the cheques received in the post office box are not delivered either by the post office or the firm itself to the bank; rather, the bank itself picks them up at the post office.

 

Thus, the lock-box system, as a method of collection of receivables, has a two-fold advantage:

(i)      the bank performs the clerical task of handling the remittances prior to deposits, services which the bank may be able to perform at lower cost;

(j)     the process of collection through the banking system begins immediately upon the receipt of the cheque / remittance and does not have to wait until the firm completes its processing for internal accounting purpose.

           

As a result, the time lag between payment by a customer and the availability of funds to the firm for use would be reduced and, thereby, the collection of receivables would be accelerated.

 

Although the use of concentration banking and lock-box systems accelerate the collection of receivables, they involve a cost. While in the case of the former, the cost is in terms of the maintenance of multiple collection centers, compensation to the bank for services represents the cost associated with the latter. The justification for the use or otherwise of these special cash management techniques would be based on a comparison of the cost with the return generated on the released funds. If the income exceeds the cost, the system is profitable and should be used; otherwise, not. For this reason, these techniques can be pressed into service only by large firms, which receive a large number of cheques from a wide number of cheques from a wide geographical area.

 

STRATEGIES FOR MANAGING SURPLUS FUNDS

 

Keith V Smith says, in one of his financial management book, that financial managers can consider a series of seven strategies for handling the excess cash balance with the firm.

 

1)      Do nothing The finance manager simply allows surplus liquidity to accumulate in a somewhat in the current account. This strategy enhances liquidity at the expense of profits that could be earned from investing surplus funds.

 

2)      Make Ad Hoc Investments The financial manager makes investments in a somewhat ad hoc manner. Such a strategy makes some contribution, though not the optimum contribution, to profitability without improving the liquidity of the firm. It is followed by firms, which cannot devote enough time and resource to management securities.

 

3)      Rides the Yield Curve This is a strategy to increase the yield from a portfolio of marketable securities by betting on interest rate changes. If the financial manager expects that interest rates will fall in the near future, he would buy long-term securities as they appreciate more, compared to shorter-term securities, when interest rates fall. On the other hand, if the financial manager believes that the interest rate will rise in the near future, he would sell longer-term securities. This strategy hinges on the assumption that the financial manager has superior interest rate forecasting ability. Empirical evidence, however, suggests that it may be futile to try to do better than average. The expected higher return is almost invariably accompanied by higher risk.

 

4)      Develop Guidelines A firm may develop a set of guidelines, which may reflect the view of the management towards risk and return.

 

Examples of such guidelines are:

(i)                  Do not speculate on interest rate changes.

(ii)                Hold marketable securities till they mature.

(iii)               Do not put more than a certain percentage of liquid funds in a particular security or type of security.

(iv)              Minimize transaction costs.

 

Using a set of guidelines, which supposedly reflect conventional wisdom often provides a ‘satisfying’ solution to be orderly and systematic.

 

5)      Utilize Control Limits There are some models of cash management, which assume that cash inflows and outflows occur randomly over time. Based on this premise, these models define the upper and lower control limits. When the cash balance touches the upper limit the model prescribes that a certain amount should be invested in marketable securities. By the same token, when the cash balance hits the lower control limits the model says that a certain amount of marketable securities should be liquidated to augment the cash resources of the firm. Of course a control limit model does not specify which securities should be bought or sold. Hence, such a model is essentially a partial device for managing liquidity.

 

6)      Manage with a Portfolio Perspective According to the portfolio theory there are two key steps in portfolio selection.

·        Define the Efficient Frontier The efficient frontier represents a collection of all efficient portfolios. A portfolio is efficient if (and only if) there is no alternative with (i) the same expected return and a lower standard deviation, or (ii) the same standard deviation and a higher expected return, or (iii) a higher expected return and a lower standard deviation.

·        Select the Optimal Portfolio The optimal portfolio is that point on the efficient frontier, which enables the investor to achieve the highest attainable level of utility indifference curve.

 

Although portfolio theory has been developed in terms of explicit formulate for risk and return, in the present context it may be viewed as a general approach that emphasizes the principle of diversification. The portfolio theory, of course, does not provide much guidance on how funds should be switched from the cash account to marketable securities and vice versa. Hence, it is also a partial approach to liquidity management.   

 

7)      Follow a Mechanical Procedure The financial manager may switch funds between the cash account and marketable using a mechanical procedure. Some models have been developed that provide rules for such mechanical procedures. The success of such a strategy depends on how well the behavior of the firm’s cash flows conforms to the assumption of the model. It appears that, in practice, mechanical procedures are of rather limited use.

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