Cash management

Cash Management

Cash is a key part of working capital management.

Companies need to carry sufficient levels of cash in order to ensure they can meet day-to-day expenses. Cash is also required to be held as a cushion against unplanned expenditure, to guard against liquidity problems. It is also useful to keep cash available in order to be able to take advantage of market opportunities.

The cost of running out of cash may include not being able to pay debts as they fall due which can have serious operational repercussions, including the winding up of the company if it consistently fails to pay bills as they fall due. 

However, if companies hold too much cash then this is effectively an idle asset, which could be better invested and generating profit for the company.

Balancing Act

The firm faces a balancing act between liquidity and profitability. 

Cash budgets and cash flow forecasts

Cash forecast

A cash forecast is an estimate of cash receipts and payments for a future period under existing conditions. Every type of cash inflow and receipt, along with their timings,must be forecast. Cash receipts and payments differ from sales and cost of sales in the income statement because: 

  • not all cash receipts or payments affect the income statement
  • some income statement items are derived from accounting conventions and are not cash flows
  • the timing of cash receipts and payments does not coincide with the income statement accounting period

Cash budget

A cash budget is a commitment to a plan for cash receipts and payments for a future period after taking any action necessary to bring the forecast into line with the overall business plan.

Cash budgets are used to:

  • assess and integrate operating budgets
  • plan for cash shortages and surpluses
  • compare with actual spending.

Companies are likely to prepare a cash budget as part of the annual master budget, but then to continually prepare revised cash forecasts throughout the year, as a means of monitoring and managing cash flows.

Proforma cash forecast

Preparing a cash flow forecast from working capital ratios  Working capital ratios can be used to forecast future cash requirements, by using the working capital ratios to work out the working capital requirement. This technique can be used to help forecast overall cash flow.

Treasury management

Treasury management is heavily concerned with liquidity and covers the following activities:

  • banking and exchange
  • cash and currency management
  • investment in short-term assets
  • risk and insurance
  • raising finance.

All treasury management activities are concerned with managing the liquidity of a business, the importance of which to the survival and growth of a business cannot be over-emphasised.

Need for a treasury department

The functions carried out by the treasurer have always existed, but have been absorbed historically within other finance functions. A number of reasons may be identified for the modern development of separate treasury departments:

  • size and internationalisation of companies: these factors add to both the scale and the complexity of the treasury functions
  • size and internationalisation of currency, debt and security markets: these make the operations of raising finance, handling transactions in multiple currencies and investing, much more complex. They also present opportunities for greater gains
  • sophistication of business practice: this process has been aided by modern communications, and as a result the treasurer is expected to take advantage of opportunities for making profits or minimising costs which did not exist a few years ago.

For these reasons, most large international corporations have moved towards setting up a separate treasury department. Treasury departments tend to rely heavily on new technology for information.

Responsibilities of a treasury management function

The treasurer will generally report to the finance director, with a specific emphasis on borrowing and cash and currency management. The treasurer will have a direct input into the finance director's management of debt capacity, debt and equity structure, resource allocation, equity strategy and currency strategy.

The treasurer will be involved in investment appraisal, and the finance director will often consult the treasurer in matters relating to the review of acquisitions and divestments, dividend policy and defence from takeover.

Short-term investment and borrowing solutions

A company must choose from a range of options to select the most appropriate source of investment/funding.

Short-term cash investments

Short-term cash investments are used for temporary cash surpluses.To select an investment, a company has to weigh up three potentially conflicting objectives and the factors surrounding them:

  • Liquidity: the cash must be available for use when needed.
  • Safety: no risk of loss must be taken.
  • Profitability: subject to the above, the aim is to earn the highest possible after-tax returns.

Each of the three objectives raises problems.

The liquidity problem

At first sight this problem is simple enough. If a company knows that it will need the funds in three days (or weeks or months), it simply invests them for just that period at the best rate available with safety. The solution is to match the maturity of the investment with the period for which the funds are surplus. However there are a number of factors to consider:

The exact duration of the surplus period is not always known. It will be known if the cash is needed to meet a loan instalment, a large tax payment or a dividend. It will not be known if the need is unidentified, or depends on the build-up of inventory, the progress of construction work, or the hammering out of an acquisition deal.

The safety problem

Safety means there is no risk of capital loss. Superficially this again looks simple. The concept certainly includes the absence of credit risk. For example, the firm should not deposit with a bank which might conceivably fail within the maturity period and thus not repay the amount deposited.

However, safety is not necessarily to be defined as certainty of getting the original investment repaid at 100% of its original home currency value. If the purpose for which the surplus cash is held is not itself fixed in the local currency, then other criteria of safety may apply.

The profitability problem

The profitability objective looks deceptively simple at first: go for the highest rate of return subject to the overriding criteria of safety and liquidity. However, here there are complications.

Short-term borrowing

Short-term cash requirements can also be funded by borrowing from the bank. There are two main sources of bank lending:

  • bank overdraft
  • bank loans.

Bank overdrafts

A common source of short-term financing for many businesses is a bank overdraft. These are mainly provided by the clearing banks and represent permission by the bank to write cheques even though the firm has insufficient funds deposited in the account to meet the cheques.

An overdraft limit will be placed on this facility, but provided the limit is not exceeded, the firm is free to make as much or as little use of the overdraft as it desires. The bank charges interest on amounts outstanding at any one time, and the bank may also require repayment of an overdraft at any time.

The advantages of overdrafts are the following.

  • Flexibility as they can be used as required.
  • Cheapness as interest is only payable on the finance actually used, usually at 2-5% above base rate (and all loan interest is a tax deductible expense).

The disadvantages of overdrafts are as follows.

  • Overdrafts are legally repayable on demand. Normally, however, the bank will give customers assurances that they can rely on the facility for a certain time period, say six months.
  • Security is usually required by way of fixed or floating charges on assets or sometimes, in private companies and partnerships, by personal guarantees from owners.
  • Interest costs vary with bank base rates. This makes it harder to forecast and exposes the business to future increases in interest rates.

Bank loans

Bank loans are a contractual agreement for a specific sum, loaned for a fixed period, at an agreed rate of interest. They are less flexible and more expensive than overdrafts but provide greater security.

A bank loan represents a formal agreement between the bank and the borrower, that the bank will lend a specific sum for a specific period (one to seven years being the most common). Interest must be paid on the whole of this sum for the duration of the loan.

This source is, therefore, liable to be more expensive than the overdraft and is less flexible but, on the other hand, there is no danger that the source will be withdrawn before the expiry of the loan period. Interest rates and requirements for security will be similar to overdraft lending.

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Cash management models

Cash management models are aimed at minimising the total costs associated with movements between a company's current account (very liquid but not earning interest) and their short-term investments (less liquid but earning interest).

The models are devised to answer the questions:

  • at what point should funds be moved?
  • how much should be moved in one go?

The Baumol cash management model

Baumol noted that cash balances are very similar to inventory levels, and developed a model based on the economic order quantity(EOQ).Assumptions:

  • cash use is steady and predictable
  • cash inflows are known and regular
  • day-to-day cash needs are funded from current account
  • buffer cash is held in short-term investments.

The formula calculates the amount of funds to inject into the current account or to transfer into short-term investments at one time:


CO = transaction costs (brokerage,commission, etc.)

D = demand for cash over the period

CH = cost of holding cash.

The model suggests that when interest rates are high, the cash balance held in non-interest-bearing current accounts should be low. However its weakness is the unrealistic nature of the assumptions on which it is based.

Example using the Baumol model

A company generates $10,000 per month excess cash, which it intends to invest in short-term securities. The interest rate it can expect to earn on its investment is 5% pa. The transaction costs associated with each separate investment of funds is constant at $50.


(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 pa?

(d)What is the opportunity cost of holding cash pa?


The Miller-Orr cash management model

The Miller-Orr model is used for setting the target cash balance for a company.

The diagram below shows how the model works over time.

  • The model sets higher and lower control limits, H and L, respectively, and a target cash balance, Z.
  • When the cash balance reaches H, then (H-Z) dollars are transferred from cash to marketable securities, i.e. the firm buys (H-Z) dollars of securities.
  • Similarly when the cash balance hits L, then (Z-L) dollars are transferred from marketable securities to cash.

The lower limit, L is set by management depending upon how much risk of a cash shortfall the firm is willing to accept, and this, in turn, depends both on access to borrowings and on the consequences of a cash shortfall.

The formulae for the Miller-Orr model are:

Return point = Lower limit + (1/3 × spread)

Spread = 3 [ (3/4 × Transaction cost × Variance of cash flows) ÷ Interest rate ] 1/3

Note: variance and interest rates should be expressed in daily terms. Variance = standard deviation squared. 

Example using the Miller-Orr model

The minimum cash balance of $20,000 is required at Miller-Orr Co,and 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 (standard deviation squared) is $9 million. The interest rate is 0.03% per day.


(i)the spread between the upper and lower limits

(ii) the upper limit

(iii)the return point.


(i)Spread = 3 (3/4 × 50× 9,000,000/0.0003)1/3 = $31,200

(ii) Upper limit = 20,000 + 31,200 = $51,200

(iii)Return point = 20,000 + 31,200/3 = $30,400


Created at 9/5/2012 10:54 AM  by System Account  (GMT) Greenwich Mean Time : Dublin, Edinburgh, Lisbon, London
Last modified at 11/1/2016 4:28 PM  by System Account  (GMT) Greenwich Mean Time : Dublin, Edinburgh, Lisbon, London

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