Under Previous Sections , the trade-off between profitability and risk was studied in respect of the proportion of current assets (or current liabilities) within the total assets (or total liabilities). Therein, liquid assets were defined as cash and marketable securities.Not only are these the most liquid assets; also the other major current assets, viz. receivables and inventory, get eventually converted into cash. This signifies the importance of cash management along with the management of marketable securities. Accordingly, the ensuring articles discuss the ways for. determining the appropriate amounts to carry in each of these assets, with the purpose being to meet out the payments to be made as they become due, to examine methods for improving the efficiency of cash management, and to study the investment of excess funds in marketable securities.
Motives for Holding Cash
Whether hold as cash proper (currency and coins and bank balances) or as its equivalents (cheques, drafts and demand deposits) or as near-cash assets (marketable securities or time deposits) which can be readily sold/converted into cash, these assets have no (or next to nil) earning power, with the latter forms providing a short-term investment medium for excess cash. If cash does not earn any return, what then is the motive for holding of cash by firms and organisations?Three primary motives and a fourth unavoidable motive (rather an incidental fix) are as follows :
(a) Transaction motive;
(b) Precautionary motive;
(c) Speculative motive; and
(d) Compensation motive.
Transaction Motive
This refers to the holding of cash to meet routine payments arising in the ordinary course of the business - as for purchases, labour wages, operating expenses,financial charges (like taxes, dividends and interest). Of course, there would also be regular inflow of cash to the firm from sales operations (which, as often happens, results in a good proportion of receivables as compared to cash receipts) and returns from outside/external investments. But the inflows may not exactly be matching the disbursements to be made either in timing or in quantum. To ensure that the firm can meet its payment obligations as they become due, the firm must have the appropriate amount of ready cash balance. The cash balance maintained for, and arising from, such routine transactions is called as rransaction balance.IThough a major part of transaction balances are held in cash, a part may also be as marketable securities whose maturity will conform to the timing of the anticipated payments, like for payment of taxes and dividends.
Precautionary Motive
Besides the cash inflows and outflows anticipatable in the ordinary or routine course of business, the firm may have to pay out cash for purposes that cannot be predicted, like due to :
(a) floods, strikes, or other natural events;
(b) increase in cost of raw materials;
(c) default in customers paying in;
(d) slack collection of accounts receivable; and
(e) early demands for settling credits.
Cash balances held in reserve for such unforeseeable demands are called precautionary balances. It may be wise to keep these in the form of marketable securities or demand deposits. A cushion or buffer is maintained to meet unforeseen contingencies. This can be met out of short-term borrowings also.
Speculative Motive
This refers to the holding of cash with the motive of taking advantage of unexpected opportunities outside the normal course of business, like changes in security prices. Whereas the precautionary motive is defensive for tiding over unanticipated contingencies, speculative motive is for exploiting opportunities to advantage. Examples are : Purchase of raw material when prices decline suddenly;buying securities when interest rates are likely to decline. However, this being outside the normal course of business and hence incapable of being planned for,this is not discussed further.
Compensation Motive
Bank balances are to be kept at not less than a minimum level to compensate banks for providing certain services and loans. One important service provided is the clearance of cheques. The banks use the amount of earn a return to get compensated for their services. Such balances are required also for some loan agreements. From the firm's viewpoint, this is dead money.
Objectives/Functions of Cash Management
Cash management is towards the purposes of
(i) meeting payment schedules (i.e. being able to make cash disbursements as the needs arise), and
(ii) minimising funds in the form of cash (and bank balances).
As in most sets of objectives, these two are mutually contradictory :
(a) lets the firm earn no return but liquidity is ensured, whereas
(b) lets the firm earn a return but cash is not always instantly available to improve liquidity.
The main instrument through which these objectives are served is the preparation of cash budget which is to inform on how much cash should be held, when and for how long.Besides this, and also to prepare this, the firm must have a systematic information flow on cash inflows and outflows projections for a certain planning horizon (daily, monthly, quarterly, semi-annually and also annually, and for major events/occasions). Information should cover (how much, when, how long - as said above) on payments for goods, services, staff, contingent expenditure, collection from debtors, interest - receipts and dues to be paid, taxes, dividends, commissions to be paid and trade discounts to be given or availed off. The emphasis is on prompt payment (and collection) of cash - by keeping sufficient (or adequate) but not excessive cash. So much on the payments schedule. The second purpose arises from the conflict between having to keep a large fund of cash on hand as a non-earning asset but meeting all the payments schedule on the one hand and being short of cash whereby failing to meet the payment schedule on the other. The cost of being short of cash to meet the cash needs, i.e. "short cost", is assignable under different heads.
These are as follows :
(a) Transaction costs, e.g. brokerage for the sale of marketable securities to get cash;
(b) Borrowing costs, e.g. interest on loan or overdraft, commitment charges, etc.;
(c) Loss of trade discount;
(d) Penalty rates payable to banks when minimum balance is not maintained.
At the other end, if any excess cash is maintained as securities, etc., these involve staff costs, other handling costs, etc. Incidentally, as has been implied above, overdraft is a commonly used facility to overcome cash shortages.
Cash Budget
Preparation of cash budget helps the firm to plan for, and control the use of, cash. It shows estimated cash income and cash expenditure for the planning horizon. It has to be updated at frequent intervals. By the difference between cash income and cash expenditure, as estimated, the net cash position, i.e. in surplus or in deficiency, is also established along with the amount thereof. When excess cash is likely to be available,materials can be purchased on cash discounts, accounts payable can be settled, dividends can be paid, capital expenditure can be made, reserves can be generated, taxes can be paid, etc. When shortages are forecast, mobilisation to meet the shortage can be undertaken - through sale of securities, arranging for loans and overdrafts, etc. The selected planning horizon should not be too long whereby the accuracies of estimates can become questionable, nor too short calling for disproportionately large effort in its preparation. In any case, isolated major events should not be lost sight of. If seasonal variations are likely, due care should be taken to incorporate them by reducing the time steps between successive dates of the estimations. Also, only cash items must be included, non-cash items (like depreciation except for tax purposes) should be excluded. Factors to be considered as generating cash flow are under two categories : operating and financial.
Operating Cash Flows
Herein are included cash flows generated by the operations by the firm.
Cash intlows arise from :
(i) Cash sales; (ii) Collection of accounts receivable; and (iii) Sale of fixed assets.
Cash outflows occur by :
(i) Payment on Accounts Payable; (ii) Pay roll; (iii) Purchase of fixed assets; (iv) Purchase of raw materials; (v) Other expenses - factory, administrative and selling, maintenance, etc.
What has been discussed under Unit 15 (Effects of real market mechanism on cash outflows) is a typical illustration of operating cash flow (only cash outflows have been considered there) as adoptable by construction industry.
A further illustration is now presented.
Example
A firm purchases raw materials worth Rs. 80,000 in the months of June and July and Rs. 1,00,000 in the months of August, September and October under trade credit terms : "211, net 213" (meaning 2% discount if paid within 1 month of purchase, full amount to be paid if within the 2nd month, and to pay with simple interest of 3% per month if paid later). It has been able to avail of the discount onl. on the purchases of July and September. Purchases in the month of August were settled in October. Others were paid by the full amount. All purchases were at the beginning of the respective month.Based on its continuous production, its gross sales have been for Rs. 1.2 lakhs,1.3 lakhs, 1.0 lakh, 1.2 lakhs and 0.9 lakh in the months June to October,successively. Of these, on an average, 40% were by cash sales, 40% were paid for by the customers during the next month and balance 20%, a further month later.The firm sold old equipment for Rs. 50,000 cash in July and replaced it by a new equipment in September at a cost of Rs. 85,000 paid in full. Wage bills were uniformly Rs. 8,000 pm. For purposes of collection, the concerned staff have been paid 1 % of the collections, immediately in cash. Factory expenses, including administrative and maintenance, have been Rs. 4,000 uniformly every month. You are required to prepare a "Work Sheet" for the operating cash flow.
Solution
Following may be noted with respect to table :
(a) Figures in thousand of Rupees.
(b) Outflows are shown by, -; and inflows by, +.
(c) Figures in brackets are only for working purposes.
(d) For operating cash flow : DI stands for : Data Incomplete.
Motives for Holding Cash
Whether hold as cash proper (currency and coins and bank balances) or as its equivalents (cheques, drafts and demand deposits) or as near-cash assets (marketable securities or time deposits) which can be readily sold/converted into cash, these assets have no (or next to nil) earning power, with the latter forms providing a short-term investment medium for excess cash. If cash does not earn any return, what then is the motive for holding of cash by firms and organisations?Three primary motives and a fourth unavoidable motive (rather an incidental fix) are as follows :
(a) Transaction motive;
(b) Precautionary motive;
(c) Speculative motive; and
(d) Compensation motive.
Transaction Motive
This refers to the holding of cash to meet routine payments arising in the ordinary course of the business - as for purchases, labour wages, operating expenses,financial charges (like taxes, dividends and interest). Of course, there would also be regular inflow of cash to the firm from sales operations (which, as often happens, results in a good proportion of receivables as compared to cash receipts) and returns from outside/external investments. But the inflows may not exactly be matching the disbursements to be made either in timing or in quantum. To ensure that the firm can meet its payment obligations as they become due, the firm must have the appropriate amount of ready cash balance. The cash balance maintained for, and arising from, such routine transactions is called as rransaction balance.IThough a major part of transaction balances are held in cash, a part may also be as marketable securities whose maturity will conform to the timing of the anticipated payments, like for payment of taxes and dividends.
Precautionary Motive
Besides the cash inflows and outflows anticipatable in the ordinary or routine course of business, the firm may have to pay out cash for purposes that cannot be predicted, like due to :
(a) floods, strikes, or other natural events;
(b) increase in cost of raw materials;
(c) default in customers paying in;
(d) slack collection of accounts receivable; and
(e) early demands for settling credits.
Cash balances held in reserve for such unforeseeable demands are called precautionary balances. It may be wise to keep these in the form of marketable securities or demand deposits. A cushion or buffer is maintained to meet unforeseen contingencies. This can be met out of short-term borrowings also.
Speculative Motive
This refers to the holding of cash with the motive of taking advantage of unexpected opportunities outside the normal course of business, like changes in security prices. Whereas the precautionary motive is defensive for tiding over unanticipated contingencies, speculative motive is for exploiting opportunities to advantage. Examples are : Purchase of raw material when prices decline suddenly;buying securities when interest rates are likely to decline. However, this being outside the normal course of business and hence incapable of being planned for,this is not discussed further.
Compensation Motive
Bank balances are to be kept at not less than a minimum level to compensate banks for providing certain services and loans. One important service provided is the clearance of cheques. The banks use the amount of earn a return to get compensated for their services. Such balances are required also for some loan agreements. From the firm's viewpoint, this is dead money.
Objectives/Functions of Cash Management
Cash management is towards the purposes of
(i) meeting payment schedules (i.e. being able to make cash disbursements as the needs arise), and
(ii) minimising funds in the form of cash (and bank balances).
As in most sets of objectives, these two are mutually contradictory :
(a) lets the firm earn no return but liquidity is ensured, whereas
(b) lets the firm earn a return but cash is not always instantly available to improve liquidity.
The main instrument through which these objectives are served is the preparation of cash budget which is to inform on how much cash should be held, when and for how long.Besides this, and also to prepare this, the firm must have a systematic information flow on cash inflows and outflows projections for a certain planning horizon (daily, monthly, quarterly, semi-annually and also annually, and for major events/occasions). Information should cover (how much, when, how long - as said above) on payments for goods, services, staff, contingent expenditure, collection from debtors, interest - receipts and dues to be paid, taxes, dividends, commissions to be paid and trade discounts to be given or availed off. The emphasis is on prompt payment (and collection) of cash - by keeping sufficient (or adequate) but not excessive cash. So much on the payments schedule. The second purpose arises from the conflict between having to keep a large fund of cash on hand as a non-earning asset but meeting all the payments schedule on the one hand and being short of cash whereby failing to meet the payment schedule on the other. The cost of being short of cash to meet the cash needs, i.e. "short cost", is assignable under different heads.
These are as follows :
(a) Transaction costs, e.g. brokerage for the sale of marketable securities to get cash;
(b) Borrowing costs, e.g. interest on loan or overdraft, commitment charges, etc.;
(c) Loss of trade discount;
(d) Penalty rates payable to banks when minimum balance is not maintained.
At the other end, if any excess cash is maintained as securities, etc., these involve staff costs, other handling costs, etc. Incidentally, as has been implied above, overdraft is a commonly used facility to overcome cash shortages.
Cash Budget
Preparation of cash budget helps the firm to plan for, and control the use of, cash. It shows estimated cash income and cash expenditure for the planning horizon. It has to be updated at frequent intervals. By the difference between cash income and cash expenditure, as estimated, the net cash position, i.e. in surplus or in deficiency, is also established along with the amount thereof. When excess cash is likely to be available,materials can be purchased on cash discounts, accounts payable can be settled, dividends can be paid, capital expenditure can be made, reserves can be generated, taxes can be paid, etc. When shortages are forecast, mobilisation to meet the shortage can be undertaken - through sale of securities, arranging for loans and overdrafts, etc. The selected planning horizon should not be too long whereby the accuracies of estimates can become questionable, nor too short calling for disproportionately large effort in its preparation. In any case, isolated major events should not be lost sight of. If seasonal variations are likely, due care should be taken to incorporate them by reducing the time steps between successive dates of the estimations. Also, only cash items must be included, non-cash items (like depreciation except for tax purposes) should be excluded. Factors to be considered as generating cash flow are under two categories : operating and financial.
Operating Cash Flows
Herein are included cash flows generated by the operations by the firm.
Cash intlows arise from :
(i) Cash sales; (ii) Collection of accounts receivable; and (iii) Sale of fixed assets.
Cash outflows occur by :
(i) Payment on Accounts Payable; (ii) Pay roll; (iii) Purchase of fixed assets; (iv) Purchase of raw materials; (v) Other expenses - factory, administrative and selling, maintenance, etc.
What has been discussed under Unit 15 (Effects of real market mechanism on cash outflows) is a typical illustration of operating cash flow (only cash outflows have been considered there) as adoptable by construction industry.
A further illustration is now presented.
Example
A firm purchases raw materials worth Rs. 80,000 in the months of June and July and Rs. 1,00,000 in the months of August, September and October under trade credit terms : "211, net 213" (meaning 2% discount if paid within 1 month of purchase, full amount to be paid if within the 2nd month, and to pay with simple interest of 3% per month if paid later). It has been able to avail of the discount onl. on the purchases of July and September. Purchases in the month of August were settled in October. Others were paid by the full amount. All purchases were at the beginning of the respective month.Based on its continuous production, its gross sales have been for Rs. 1.2 lakhs,1.3 lakhs, 1.0 lakh, 1.2 lakhs and 0.9 lakh in the months June to October,successively. Of these, on an average, 40% were by cash sales, 40% were paid for by the customers during the next month and balance 20%, a further month later.The firm sold old equipment for Rs. 50,000 cash in July and replaced it by a new equipment in September at a cost of Rs. 85,000 paid in full. Wage bills were uniformly Rs. 8,000 pm. For purposes of collection, the concerned staff have been paid 1 % of the collections, immediately in cash. Factory expenses, including administrative and maintenance, have been Rs. 4,000 uniformly every month. You are required to prepare a "Work Sheet" for the operating cash flow.
Solution
Following may be noted with respect to table :
(a) Figures in thousand of Rupees.
(b) Outflows are shown by, -; and inflows by, +.
(c) Figures in brackets are only for working purposes.
(d) For operating cash flow : DI stands for : Data Incomplete.
Remarks
Two aspects are intriguing. Firstly, if the firm has been able to pay for the arrears of June as well as for the current month of July during July and has also been having a surplus cash flow of Rs. 1,03,240 in August, why should it not have paid for the August purchases in August itself; by not doing so, it has lost Rs. 2,000 of discount in August. Perhaps the cost of purchase of equipment
came in the way.
Secondly, if the August purchase had been paid for in September and the September purchase had been paid for in October, the combined outgo would have been only Rs. 2,00,000, against Rs. 2,04,000 as of now. Such deep analysis must be deliberated when drawing the budget.
Financial Cash Flows
The detailed working under Sections 19.7 under "Reconciliation of Earnings" and 19.10 can be recalled. EBIDTA had already considered the items that go into operating cash flow. Other and related items which are not directly because of operations (in the line of business of the firm) but only in the context of arranging for the funds needs ultimately for the operations come under financial cash flows.
The following are typical.
Cash idlows (or receipts) comprise :
(i) Issue of new shares and securities as well as loans and borrowings; (ii) Sale of securities; (iii) Rents received; (iv) Interest received; (v) Dividends received; (vi) Refunds received, particularly on taxes.(Notional receipts like on discounts are irrelevant; also to note is that these have been considered under operating cash flow in net costs. Also, notional increases in cash due revaluations are not to be considered.)
Cash outflows (or payments) typically consist of :
(i) Tax payments; (ii) Interest paid; (iii) Redemption of loan; (iv) Dividends paid; and (v) Repurchase of shares.
Financial cashflows are to be judiciously projected so as to smoothen out the variations and difficult deficiencies and relieving excesses in the operating cash flow; this is done by suitably timing the components of the cash inflows and cash outflows'of the financial cashflows.
Cash Budget
After the operating and financial cashflows have been decided upon, these are merged together, and any other omitted or relatable items are also included to prepare the cash budget. The preparation of cash budget is illustrated through a worked example.
Example
The following information is available in respect of a construction firm, which is executing a job on contract-by-tender during January to August. Amounts are in lakhs of rupees.
Two aspects are intriguing. Firstly, if the firm has been able to pay for the arrears of June as well as for the current month of July during July and has also been having a surplus cash flow of Rs. 1,03,240 in August, why should it not have paid for the August purchases in August itself; by not doing so, it has lost Rs. 2,000 of discount in August. Perhaps the cost of purchase of equipment
came in the way.
Secondly, if the August purchase had been paid for in September and the September purchase had been paid for in October, the combined outgo would have been only Rs. 2,00,000, against Rs. 2,04,000 as of now. Such deep analysis must be deliberated when drawing the budget.
Financial Cash Flows
The detailed working under Sections 19.7 under "Reconciliation of Earnings" and 19.10 can be recalled. EBIDTA had already considered the items that go into operating cash flow. Other and related items which are not directly because of operations (in the line of business of the firm) but only in the context of arranging for the funds needs ultimately for the operations come under financial cash flows.
The following are typical.
Cash idlows (or receipts) comprise :
(i) Issue of new shares and securities as well as loans and borrowings; (ii) Sale of securities; (iii) Rents received; (iv) Interest received; (v) Dividends received; (vi) Refunds received, particularly on taxes.(Notional receipts like on discounts are irrelevant; also to note is that these have been considered under operating cash flow in net costs. Also, notional increases in cash due revaluations are not to be considered.)
Cash outflows (or payments) typically consist of :
(i) Tax payments; (ii) Interest paid; (iii) Redemption of loan; (iv) Dividends paid; and (v) Repurchase of shares.
Financial cashflows are to be judiciously projected so as to smoothen out the variations and difficult deficiencies and relieving excesses in the operating cash flow; this is done by suitably timing the components of the cash inflows and cash outflows'of the financial cashflows.
Cash Budget
After the operating and financial cashflows have been decided upon, these are merged together, and any other omitted or relatable items are also included to prepare the cash budget. The preparation of cash budget is illustrated through a worked example.
Example
The following information is available in respect of a construction firm, which is executing a job on contract-by-tender during January to August. Amounts are in lakhs of rupees.
In addition to earlier information, other financial flows are as follows :
You are required to prepare the cash budget for the time horizon of January to August, assuming that there are no other businesses on hand.
Solution
Strategies in Cash Management
The omrating cash cycle has been discussed under previous Section . This is to be related with &e cashturnovir cycle. Looking at the closing balance in the Illustrative Example just dealt with, we find that the cash balance has reached a high value in March after having increased in the earlier months; then goes to a low value in June; and then again rises. Though this is merely a crude methodology of defining the cash turnover, in the absence of any other detailed analysis, one can say that the cash cycle is March to June,i.e. 3 months, or the cash turnover, is 12/3= 4 times a year. However, it must be recognised that such an attribution of cash cycle and the related cash turnover include the financial cashflows also in the definitions. It is generally preferable to base the definitions only on operating cashflows, which would then be restricted by the operating cash cycle, i.e. essentially by cash turnover related to materials - i.e. the cycle of their ordering, receipt, payment and realisation of funds. Accordingly, cash cycle is more commonly defined as : Average number of days elapsed between cash outflows by payment of accounts payable and the cash inflows by collection of accounts receivable.
Computation of Cash Cycle
Let it be that a firm pays its accounts payable in an average of 40 days (A) and collects its accounts receivable in 25 days (again on an average) (B). Also, let it be that it takes 45 days between purchase of raw materials and sale of finished goods (C).If raw material purchase is at end of day "O", sale of finished goods is at end of day "45" and, if all sales are on credit, the sale proceeds will be received at the end of day "45 + 25 = 70". The firm would have paid for *e material at the end of day "40". Hence, what has been paid at the end of day "40" has resulted in a corresponding receipt at the end of day "70", i.e. cash cycle is over (70 - 40) = 30 days, i.e. (B + C - A). And, the cash turnover will be, for a 360 days-year,
360 + 30 = 12.
Basics of Cash Management Strategies
The higher the cash turnover, the less the cash required by the firm - is the generally believed dictum. The firm must also maintain an adequate (minimum) operating cash balance. For higher cash turnover, (B + C -A) as hereinabove must be minimised, i.e. B and C should be reduced and A should be increased. In other words,
(a) stretching the accounts payable, i.e. increasing (A);
(b) speedy collection of accounts receivable (i.e. reducing B); and
(c) improving the production efficiency and expediting the sales process (i.e. reducing C) -are the essential strategies for efficient cash management.
No doubt, any synergistic combination of these strategies will be an improved fourth strategy in this context. In particular, reducing C can be by three methods,provided stock-outs are avoided :
(a) Increasing raw materials turnover, through better inventory control; this is in respect of raw materials;
(b) Decreasing production cycle duration through better production planning, scheduling and control; this is in respect of work-in-progress; and
(c) Increasing the finished goods turnover (or sales process); this is in respect of finished goods.- thus improving cash turnover through all the three phases of inventory.
Marketable Securities
Excess cash above a target level needed for transactions and/or compensation balances is invested in marketable securities. These are short-term investment instruments to obtain a return on temporarily idle funds. These securities are convertible into cash within a few days. They thus afford marketability as well as liquidity. They have a ready market (marketability) with a large number of participants spread over a wide geographical area and there can at a time be a large number of securities so that a good amount of purchases and sales are absorbed in these transactions. The choice of the mix between keeping as cash or investing in the marketable securities is based on the trade-off between theI opportunity to earn a return on idle cash funds during the holding period and the
brokerage costs to purchase and sell these securities. Their maturity is often much less than a year. If brokerage is at 0.3% for purchase and 0.35% for sale and if the yield on annual basis (on pro-rata monthly basis) is 7.896, then to hold for just a month breaks even, since (0.3 + 0.35) = (7.8 t 12). In such a situation, to go in for such marketable security for periods of less than a month is loss-making; only well over one month of holding period, say 4 to 6 months, would be the right instance to go in for this type of marketable security. Moreover, securities, income on which is tax-exempt, sell in the market at lower yields to maturity than other securities of the same maturity. Also, if fixed-interest securities are sold at a discount, they invite capital tax gains on maturity.
Treasury bills, negotiable certificates of deposit and commercial paper are types of marketable securities commonly dealt with. Treasury bills sold by the government do not carry any interest but are sold at a discount; being backed by government, they are risk-free. They have an active secondary market also.Certificates of deposit are the marketable receipts for funds that have been deposited in the bank for a fixed period of time - "Indira Vikas Patra" is a typical form of these. They are not sold on discount but carry an interest till maturity. Commercial paper is short-term unsecured prornisory note sold by large business firms to raise cash. The fixed deposits taken by private firms with limited liability, issued as cash certificates, are a form of this.There is no active trading in the secondary market for commercial paper though the direct sellers of commercial paper may repurchase the paper on request if "no foreclosure" is not a pre-condition. The yield of commercial paper is generally more than for the others.The units of Unit Trust of India (UTI) are a convenient form of investment of extra cash for reason of
(a) a secondary market existing thereof;
(b) tax-exemption upto a limit on the income thereon (recently, totally); and
(c) appreciation in their value (recently, uncertainly).
Other forms of short-term investments are available but are not discussed here, two important ones among them being, since recently, eurodollars, and repurchase agreements(since a long time).
The omrating cash cycle has been discussed under previous Section . This is to be related with &e cashturnovir cycle. Looking at the closing balance in the Illustrative Example just dealt with, we find that the cash balance has reached a high value in March after having increased in the earlier months; then goes to a low value in June; and then again rises. Though this is merely a crude methodology of defining the cash turnover, in the absence of any other detailed analysis, one can say that the cash cycle is March to June,i.e. 3 months, or the cash turnover, is 12/3= 4 times a year. However, it must be recognised that such an attribution of cash cycle and the related cash turnover include the financial cashflows also in the definitions. It is generally preferable to base the definitions only on operating cashflows, which would then be restricted by the operating cash cycle, i.e. essentially by cash turnover related to materials - i.e. the cycle of their ordering, receipt, payment and realisation of funds. Accordingly, cash cycle is more commonly defined as : Average number of days elapsed between cash outflows by payment of accounts payable and the cash inflows by collection of accounts receivable.
Computation of Cash Cycle
Let it be that a firm pays its accounts payable in an average of 40 days (A) and collects its accounts receivable in 25 days (again on an average) (B). Also, let it be that it takes 45 days between purchase of raw materials and sale of finished goods (C).If raw material purchase is at end of day "O", sale of finished goods is at end of day "45" and, if all sales are on credit, the sale proceeds will be received at the end of day "45 + 25 = 70". The firm would have paid for *e material at the end of day "40". Hence, what has been paid at the end of day "40" has resulted in a corresponding receipt at the end of day "70", i.e. cash cycle is over (70 - 40) = 30 days, i.e. (B + C - A). And, the cash turnover will be, for a 360 days-year,
360 + 30 = 12.
Basics of Cash Management Strategies
The higher the cash turnover, the less the cash required by the firm - is the generally believed dictum. The firm must also maintain an adequate (minimum) operating cash balance. For higher cash turnover, (B + C -A) as hereinabove must be minimised, i.e. B and C should be reduced and A should be increased. In other words,
(a) stretching the accounts payable, i.e. increasing (A);
(b) speedy collection of accounts receivable (i.e. reducing B); and
(c) improving the production efficiency and expediting the sales process (i.e. reducing C) -are the essential strategies for efficient cash management.
No doubt, any synergistic combination of these strategies will be an improved fourth strategy in this context. In particular, reducing C can be by three methods,provided stock-outs are avoided :
(a) Increasing raw materials turnover, through better inventory control; this is in respect of raw materials;
(b) Decreasing production cycle duration through better production planning, scheduling and control; this is in respect of work-in-progress; and
(c) Increasing the finished goods turnover (or sales process); this is in respect of finished goods.- thus improving cash turnover through all the three phases of inventory.
Marketable Securities
Excess cash above a target level needed for transactions and/or compensation balances is invested in marketable securities. These are short-term investment instruments to obtain a return on temporarily idle funds. These securities are convertible into cash within a few days. They thus afford marketability as well as liquidity. They have a ready market (marketability) with a large number of participants spread over a wide geographical area and there can at a time be a large number of securities so that a good amount of purchases and sales are absorbed in these transactions. The choice of the mix between keeping as cash or investing in the marketable securities is based on the trade-off between theI opportunity to earn a return on idle cash funds during the holding period and the
brokerage costs to purchase and sell these securities. Their maturity is often much less than a year. If brokerage is at 0.3% for purchase and 0.35% for sale and if the yield on annual basis (on pro-rata monthly basis) is 7.896, then to hold for just a month breaks even, since (0.3 + 0.35) = (7.8 t 12). In such a situation, to go in for such marketable security for periods of less than a month is loss-making; only well over one month of holding period, say 4 to 6 months, would be the right instance to go in for this type of marketable security. Moreover, securities, income on which is tax-exempt, sell in the market at lower yields to maturity than other securities of the same maturity. Also, if fixed-interest securities are sold at a discount, they invite capital tax gains on maturity.
Treasury bills, negotiable certificates of deposit and commercial paper are types of marketable securities commonly dealt with. Treasury bills sold by the government do not carry any interest but are sold at a discount; being backed by government, they are risk-free. They have an active secondary market also.Certificates of deposit are the marketable receipts for funds that have been deposited in the bank for a fixed period of time - "Indira Vikas Patra" is a typical form of these. They are not sold on discount but carry an interest till maturity. Commercial paper is short-term unsecured prornisory note sold by large business firms to raise cash. The fixed deposits taken by private firms with limited liability, issued as cash certificates, are a form of this.There is no active trading in the secondary market for commercial paper though the direct sellers of commercial paper may repurchase the paper on request if "no foreclosure" is not a pre-condition. The yield of commercial paper is generally more than for the others.The units of Unit Trust of India (UTI) are a convenient form of investment of extra cash for reason of
(a) a secondary market existing thereof;
(b) tax-exemption upto a limit on the income thereon (recently, totally); and
(c) appreciation in their value (recently, uncertainly).
Other forms of short-term investments are available but are not discussed here, two important ones among them being, since recently, eurodollars, and repurchase agreements(since a long time).
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