Concept and Basic Elements of Cash Management - Term Paper Example

Note: Word count 2,329 excluding content of Tables, Executive Summary, and References Cash Management Table of Contents Contents Contents 2 Executive Summary 2 Introduction 4 Concept and Basic Elements of Cash Management 4 Cash Management Devices 6 Cash Management Techniques/Processes 14 Conclusion 16 Recommendations 17 Reference List 17 Executive Summary Since cash a common medium of exchange, provides purchasing power, and a very important component of work capital, availability of cash is critical to business activities. Business organisations need for cash led to widespread adaptation and application of methods and processes for managing working capital including cash optimisation procedures and techniques popularly known as Cash Management. Exploration of Cash Management or CM concept, aims and objectives, beneficial effects, devices, procedures and techniques, and effectiveness in managing cash suggest that CM is exceptionally valuable. This is because aside from the ability to predict future earnings and expenditures, it enhances efficiency of cash flows and cash balances by accelerating payment collection and conversion, systematic cash disbursement techniques, and effective management of idle funds. It helps avoid both cash shortfalls and surpluses; it helps maintain organisations good relationship with suppliers through systematic disbursement of funds; it improves business profitability by eliminating the need for financing and worthwhile utilization of idle cash. However, since CM demands proficiency, coordination, and consistency in cash optimisation process and business practices, the success of business organisations considering CM’s potential depends on how well they are organised, knowledge of CM and disciplined business practices, enthusiasm, and consistency in the use and application of CM devices and techniques. Introduction Businesses often require effective management of different resources such as people, equipment, property, products, cash, and others. However, cash is considered the most important as it is the only resource that maintains a constant value, can easily be turned into other asset, and provide businesses the ability to buy other resources that may be deficient . Businesses commonly employ Cash Management devices and techniques to plan and predict future earnings and expenses, maximize cash mobilization, enhance efficiency of cash flows and cash balances, monitor and reduce idle cash, and make short-term investment when the right opportunities come. The following sections discusses the various aspects of cash management including useful devices and techniques for forecasting sales and disbursement, controlling cash inflows and outflows, monitoring firm’s cash position through cash flow ratios, models for determining optimal cash balance level, balancing payments against disbursement, and managing surplus cash. Concept and Basic Elements of Cash Management Concept, Aims, Objectives, and Motives in the Application CM Cash management or CM is an important aspect of working capital management which is a managerial accounting strategy to enhance the efficiency of current assets and current liabilities . The primary aims and objectives of cash management is to reduce the amount of idle cash held by a business as such cash earns no returns and manage cash flows and balances or ensuring harmony between incoming-payments and cash disbursement needs of the firm . The extent of CM application depends on business organisations’ motives to hold cash. These include the motivation to use cash for day-to-day transactions, precautionary measures in case predicted cash flows (in and out) did not turn out right and additional cash is required, and speculation or holding a certain amount of cash for future opportunities such as raw materials at bargain price, considerable cash discounts for paying bills earlier than scheduled, investing of securities at times when interest rates are lowest, and other ventures that are beneficial for the organisation . Basic Elements of Cash Management The basic elements of cash management are forecasting, mobilizing and managing the cash flow, maintaining banking relations, investing surplus cash . Usually a year, short-tem forecasting involves according to calculation, prediction, or planning future events to determine the amount of money that will be available for investment and how long the cash budget will last .Moreover, since most receipts and expenditures can be predicted, the cash budget will then provide a realistic schedule of cash flows for a given period of time. Cash mobilization on the other hand is maximizing cash balances by reducing cash collection time and delaying disbursement . The importance of maintaining banking relations is readily evident as cash mobilization, cash inflow and outflow, short-term borrowing and others will use bank facilities and services . Surplus or idle cash are cash in excess of firm’s normal cash requirement that earns no returns and therefore must be utilised effectively through temporary investment such as high liquid and low risk marketable securities, fixed assets development, reduce future obligations, debt reduction, and others to earn additional revenue and shareholder value . Along with the inflow of cash through sales, collections from debtors, and others businesses according to need to make regular and continuous cash payments to suppliers of goods, employees, and so on thus often need to have sufficient cash to meet the payment schedule. In essence, cash management prevents insolvency caused by failure to meet obligations, maintain good relationship with banks, suppliers, and others due to timely payment, provides opportunity for cash discount, and maintain optimal amount of cash balances . Since cash management in simple expression is “having the right amount of money in the right place and time”, businesses often attempt to maximize the cash turn over process by calculating the cash cycle and cash turnover and maintaining minimum amount of operating cash balance through efficient inventory management, speedy collection of accounts receivable, delaying payments on accounts payable as discussed in the following section. Cash Management Devices Cash Budget Cash Budget is a technique for planning and controlling cash receipts and payments. It help firms determine their cash needs by presenting statement of cash inflows and cash outflows for a particular period of time. The most common method for preparing cash budget for short-term period is receipts and payments method. Short-term forecast is required for preparing cash budget. An example of cash budget using this method is shown below. Requirements of this method according to are: Forecast of Cash Receipts estimated from cash receipts from cash sales, debtors, sale of investment and assets, debts, debentures, issues of shares etc... Forecast of Cash Payments from expected payment of cash for material, labour, overhead, capital expenditure and other expenditures, interest, rent, dividend, charity, income tax, and others. Outstanding expenses and accrued incomes are kept outside the range of the budget Net cash inflow or outflow for each month is calculated and shows surplus or deficit of cash. Table 1- Sample Forecasted Sales and Cash Collection November December January February March April May June July 1 Sales $1, 200 $1,600 $900 $600 $1,000 $1,500 $1,800 $1,200 Account receivables collection 2. Current Month 10% 90 60 100 150 180 120 3. Prior Month 60% 960 540 360 600 900 1,080 4. Two months ago 30% 360 480 270 180 300 450 5. Total collection from receivables $1,410 $1,330 $730 $930 $1,380 $1,650 Other collections 6. Sale of idle equipment 250 7. Total collections $1,410 $1,330 $730 $930 $1,380 $1,650 The above table shows the forecasted sales and cash collection where: Estimated average 10% of sales are collected in the month of the sale. Estimated average 60% of sales are in the month following the sale. Estimate average 30% of sales are collected in the second month following the sale. Table 2- Sample Forecasted Purchases and Cash Disbursements November December January February March April May June July 1 Sales $900 $600 $1,000 $1,500 $1,800 $1,200 $1,000 2. Raw materials purchase 40% of sales 360 240 400 600 720 480 400 3. Raw material payment 50% of raw mtl. purchase 360 240 400 600 720 480 4. Production wages 120 200 300 360 240 200 5. Administrative salaries 100 100 100 100 100 100 6. Other operating expenses 40 40 40 40 40 40 7. Income tax disbursement 60 120 120 8. Capital expenditure payment 125 150 9. Dividend payment 75 75 10. Purchase of business line 500 11. Debt repayment 1,200 12. Total disbursements $695 $1,780 $1,525 $1,295 $1,250 $940 Table 2 shows the forecasted purchases and cash disbursement where: Disbursement schedule consist of monthly, recurring, business-driven expenditures and other recurring and non-recurring periodic disbursements. Purchases of raw materials are anticipated based on forecasted sales which are on average 40% of the next month sales. Purchases are paid in the month after the purchase. Table 3 shows the combined cash collection and disbursement with net cash flows and account balances. Table 3- Net Cash Flows and Account Balances January February March April May June 1 Total collections $1,410 $1,330 $730 $930 $1,380 $1,650 2 Total disbursements 695 1,780 1,525 1,295 1, 250 940 3. Net cash flows $715 $(450) $(795) $(365) $130 $710 Account Balances 4 Beginning balance -cash $225 $940 $490 $50 $50 $50 5 + Net cash flow 715 (450) (795) (365) 130 710 6 Preliminary balance of cash 940 490 (305) (315) 180 760 7 Required short-term borrowing - - 355 365 - - 8 Payment of short-term borrowing - - - - (130) (590) 9 Ending balance-cash $940 $490 $50 $50 $50 $170 10. Ending balance-short-term debt $- $- $355 $720 $590 $- Cash Flows Statement Cash flow statement is a summarized statement showing both cash inflows and cash outflows during a particular period of time. It enables businesses to make an assessment of their ability to generate cash resources that they can utilise for different business activities. The cash flow statement can be presented either by direct or indirect method as shown in the sample cash flow statement below. Table 4- Sample Cash Flows Statement using Direct Method Statement of Cash Flows © www.excel-skills.com 2013 2012 Cash flows from operating activities Cash receipts from customers 31,150.00 26,015.00 Cash paid to suppliers and employees (29,190.00) (25,630.00) Cash generated from operations 1,960.00 385.00 Interest paid (270.00) (280.00) Income taxes paid (300.00) (45.00) Dividends paid (200.00) - Net cash from operating activities 1,190.00 60.00 Cash flows from investing activities Business acquisitions, net of cash acquired (550.00) - Purchase of property, plant and equipment (350.00) (200.00) Proceeds from sale of equipment 70.00 - Acquisition of portfolio investments - (500.00) Investment income 400.00 350.00 Net cash used in investing activities (430.00) (350.00) Cash flows from financing activities Proceeds from issue of share capital 250.00 - Proceeds from long-term borrowings 250.00 200.00 Payment of long-term borrowings (190.00) (70.00) Net cash used in financing activities 310.00 130.00 Net increase in cash and cash equivalents 1,070.00 (160.00) Cash and cash equivalents at beginning of period 160.00 320.00 Cash and cash equivalents at end of period 1,230.00 160.00 Cash Balance Control Total - - Notes to the Statement of Cash Flows 2013 2012 Cash flows from operating activities Profit before taxation 4,350.00 1,230.00 Adjustments for: Depreciation 450.00 260.00 Investment income (500.00) (350.00) Interest expense 400.00 300.00 Profit / (Loss) on the sale of property, plant & equipment (50.00) - Working capital changes: (Increase) / Decrease in trade and other receivables (500.00) (505.00) (Increase) / (Decrease) in inventories (450.00) (750.00) Increase / (Decrease) in trade payables (1,740.00) 200.00 Cash generated from operations 1,960.00 385.00 Table 5 -Sample Cash Flows Statement using Indirect Method Statement of Cash Flows © www.excel-skills.com 2013 2012 Cash flows from operating activities Profit before taxation 4,350.00 1,230.00 Adjustments for: Depreciation 450.00 260.00 Investment income (500.00) (350.00) Interest expense 400.00 300.00 Profit / (Loss) on the sale of property, plant & equipment (50.00) - Working capital changes: (Increase) / Decrease in trade and other receivables (500.00) (505.00) (Increase) / (Decrease) in inventories (450.00) (750.00) Increase / (Decrease) in trade payables (1,740.00) 200.00 Cash generated from operations 1,960.00 385.00 Interest paid (270.00) (280.00) Income taxes paid (300.00) (45.00) Dividends paid (200.00) - Net cash from operating activities 1,190.00 60.00 Cash flows from investing activities Business acquisitions, net of cash acquired (550.00) - Purchase of property, plant and equipment (350.00) (200.00) Proceeds from sale of equipment 70.00 - Acquisition of portfolio investments - (500.00) Investment income 400.00 350.00 Net cash used in investing activities (430.00) (350.00) Cash flows from financing activities Proceeds from issue of share capital 250.00 - Proceeds from long-term borrowings 250.00 200.00 Payment of long-term borrowings (190.00) (70.00) Net cash used in financing activities 310.00 130.00 Net increase in cash and cash equivalents 1,070.00 (160.00) Cash and cash equivalents at beginning of period 160.00 320.00 Cash and cash equivalents at end of period 1,230.00 160.00 Cash Balance Control Total - - Cash Flows Ratios This cash management device enables business to see their cash position where high level cash flow means improved cash earnings and liquidity. There are different types of cash flow ratios and these include cash flow to net income ratio, cash flow to operating income ratio, and reinvestment ratio equal to cash used/cash obtained . Cash flow to net income ratio is calculated by dividing the cash flows from operating activities by net income while cash flow to operating income ratio is obtained from dividing the cash flows from operating activities to operating income as shown in the examples below. Examples of Cash Flows Ratio: Cash Flow to Net Income Ratio = Cash Flows for Operating Activities / Net Income = $30, 289/$15,002 = 2.02 Cash Flow to Operating Income Ratio = Cash Flows from Operating Activities/ Operating Income = $30, 289 / 15,589 = 1.94 Common Cash Management Models The Baumol cash management model is a method commonly used to determine the maximum cash balance level . This model according to assume that cash disbursements are evenly spread, the opportunity cost of holding cash is constant, business pays a fixed transaction cost whenever it converts securities to cash, and the business is able to forecast future cash requirement with certainty. The resulting cash balances using the Baumol model resembles a saw tooth pattern as shown below where cash balances goes down to zero whenever the business spends cash. For instance, when the firm’s starting balance in its checking account reach zero, the firm deposits funds (200) to that account and the process repeat itself. Figure 1- Cash balances demonstrated by saw tooth pattern under the Baumol Model In contrast, the Miller-Orr Cash Management Model is a probabilistic model that assumes a randomly fluctuating daily cash flow . This mode incorporates uncertainties of future cash flows thus it needs two input from management – a target cash level, and lower (LCL) and upper control limits (UCL) as shown below. LCL represents management’s perceived safety level of cash while UCL is the maximum amount of cash that should be retained in the checking account or excess of cash for investment. The target level on the other hand is the ideal amount of cash that the firm should return to whenever cash balances reach either limit. Figure 2 Daily cash flows fluctuation under the Miller-Orr Cash Management Model Cash Management Techniques/Processes Accelerated Payment Collection and Conversion Managing cash flows in and out of the firm is one aspect of cash management as it can help the firm meet cash deficits or invest surplus cash in profitable and liquid opportunities . For this reason, the most common strategy is to speed up cash collections or accelerating the cash inflow process by encouraging prompt payment from customers and immediate conversion of payments into cash , take advantage of the credit terms offered by suppliers, and engage in short-term investment opportunities . The speed of collection depends on the speed of processing and despatching of invoices, the amount of time consumed by customers in clearing the bills, cheque processing and banks clearing time thus systematic planning is necessary. The most effective way to ensure prompt payment according to is through prompt billing and offering cash discount so that customers (taking advantage of considerable saving) would be eager to make early payment. Once non-cash payment (cheque, drafts, etc) is made, the strategy for conversion of payment into cash must be undertaken systematically and without delay. Managing Float Managing float (mail float, processing float, clearing float) or the time that elapses after the customer made the non-cash payment is a key technique for cash management . This is because float exist in both cash disbursement (positive float) and payment collection (negative float) which according can be extended and shortened respectively. The strategy is to accelerate receipts and slowing disbursements simultaneously or synchronizing the cash inflows and outflows in order to reduce the need for cash balances . Moreover, the shortening negative float or cash conversion cycle improves profitability as it eliminates the need for financing . Systematic Cash Disbursement In terms of cash disbursement, taking full advantage of trade credit (usually 30 days) offered by suppliers unless substantial discount are involve for early payment. However, the delay should be within acceptable limit since credit-worthiness and good business relationship with suppliers are equally important . There are two ways to control cash disbursement – zero balance account and electronic fund transfers. The zero-balance account is a cash management strategy that eliminates the need to estimate and maintain the cash balance of each disbursement account by maintaining regional bank accounts with zero balances . For instance, as banks clear checks at the end of the day, it automatically transfer just enough funds from the firm’s master account to disbursement accounts (ex. one payroll, one for payables, etc.) to cover the checks presented thus no idle cash remains . Electronic fund transfers on the other hand are a strategy where cash can be held until just prior to the due date . This strategy according to benefits firm’s disbursement by reducing administrative task and paperwork and enhances supplier relationships that would in turn benefit from reduced collection float. Managing Surplus Cash Since cash management generally aim in managing cash to attain maximum cash availability and gain maximum interest income on any idle funds, firms have a number of options for managing surplus cash. According to , businesses can use their surplus cash to reduce future obligations such as pension deficits or use this surplus cash to reduce debt particularly those carrying the highest cost to maturity. They can also invest in expansion and growth or invest on marketable securities for the cash to earn some interest . Conclusion Cash management is an important tool in working capital management as mismatches between the timing of payments and availability of cash can result to either temporary cash surpluses or cash shortfalls. Use of cash management devices ensures realistic assessment of firm’s ability to generate cash resources, meet future obligations, improve profitability, and predict the amount of money that will be available for investment. The technique and processes offered by cash management such as cash flows and float management, systematic cash disbursement and others can help businesses synchronise incoming payments with disbursement schedules, eliminate the need for financing, avoid insolvency, and maintain good relationships with banks and suppliers. Recommendations Businesses should take advantage of the benefits provided by cash management such as efficient payments collection and disbursement, use of short-term money, controlled idle funds, effective monitoring of cash movement, and others. However, firms should bear in mind that cash management requires discipline and coordinated efforts between marketing and finance, consistent use of cash management devices to monitor and control cash flows and cash balances, and application of strategies intended for maximizing cash turnover process, maintaining good relationship with banks and suppliers, and efficient use of surplus cash. Reference List Baker, H. K., & Powell, G. (2009). Understanding Financial Management: A Practical Guide: Wiley. Banjerjee, B. (2005). Financial Policy And Management Accounting 7Th Ed: Prentice-Hall Of India Pvt. Limited. Bhat, S. (2008). Financial Management: Excel Books. Brigham, E. F., & Houston, J. F. (2009). Fundamentals of Financial Management: South-Western Cengage Learning. Freidhof, J. (2006). The Dilemma of Cash Management in China: GRIN Verlag. Grosch, G. (2013). Managing Working Capital; it Depends Upon the Type of Retail Business? : GRIN Verlag. Jain, K., Khan, Y., & Jain, P. K. 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