Introduction
There are many resources that businesses use to generate profits. These resources are known as assets. Some of these assets are long-term while some are short-term. Examples of long-term assets also called fixed assets or non-current assets, are property, plant and equipment. Businesses use these assets for more than a single period to generate profits. These assets are not for sale in ordinary conditions.
On the other hand, short-term assets, also known as current assets, may include receivables, inventory, and cash and bank balances. These are known as short-term assets because they are usually used within a single period or are disposed and reacquired constantly. Managing the current assets of a business consists of different processes, such as working capital management and cash management.
What is Cash Management?
Cash management is the process of collecting and managing cash flows from different processes of a business. These processes include operating, financing and investing processes. It is part of the treasury management. The cash management process of a business can help the business manage its cash flows in a manner that results in financial stability for the business. However, cash management doesn’t only apply to businesses but is also vital for individuals.
One of the first considerations in cash management is the management of the cash flows of a business. However, it may also include managing other financial instruments of a business such as treasury bills and certificates of deposits.
Objectives of Cash Management
There are many objectives of cash management. One of the first considerations is to control the cash flows of a business. This is the most important objective of cash management. For businesses, the goal is to increase their cash inflows and decrease their cash outflows. Through proper cash management, a business can establish a much stronger position. In a proper system of cash management, a business will analyze all its cash inflows and outflows and work towards improving it.
Another objective is to enable a business to plan its cash flows. Through a proper cash management system, businesses can assess their sources of cash flows and plan more effectively. Therefore, cash management can allow businesses to budget for any future cash deficits and make plans for any expected cash surplus.
Cash management can also be used to optimize the cash levels of a business. This can help the business create a better liquidity position for itself. If the business does not have regular cash inflows, then it cannot pay its expected cash outflows on time. Therefore, effective cash management can assist a business in determining how much cash inflows are needed to meet any outflow demands.
Function of Cash Management
The functions of cash management are not limited to only managing cash. It can also include other areas of the business. First of all, one of the functions is inventory management. Cash management helps a business in managing its inventories. When a business has high amounts of inventory in stock, it means that the business is not generating any cash flows from it. Therefore, it helps a business focus on selling its inventories as quickly as possible to allow for cash generation.
Another function is receivables management. Similar to inventory, while receivables will result in cash inflows in the future, they are not cash inflows until they are received. Therefore, the function of cash management is also to help businesses recover these receivables at the earliest possible to generate cash inflows. Similarly, faster recovery of receivables also ensures that receivables do not convert into bad debts for the business.
Finally, another function is payables management. Unlike the above two functions, this function results in outflow to a business. The later a business pays its payables, the more cash it will have in its disposal. Therefore, cash management helps a business manage its payables and ensure they are only paid when needed. It can also ensure that businesses avail cash discounts, thus, resulting in cash inflows for the business.
Cash Management Model
There are different cash management models that businesses use. Two of the most commonly used models are the Baumol Model and the Miller-Orr Model. Some companies may wonder which of these two presents an effective technique to improve cash management. However, both of them represent different cash management strategies.
The Baumol Model
The Baumol Model is the first cash management model used widely by businesses.
What is the Baumol Model
The Baumol is closely related to the Economic Order Quantity (EOQ), which relates to inventory management. In EOQ, the optimal level of inventory is determined by considering the carrying and ordering costs of inventory. In this model, cash balances are considered similar to inventory levels of a business. Therefore, the same concept is applied to cash management to determine the optimal level of cash that businesses can inject into a current account or transfer to short-term investments at one time. When applied to cash management, the optimal level is determined by considering the opportunity cost or cost of borrowing or holding cash, and the transaction cost.
Formula
The formula to calculate the optimal cash level of a business using the Baumol Model is as follows:
Q = √(2COD / CH)
In the above equation, Q represents the optimal level of cash. CO represents the transactions costs (commissions, brokerage fee, etc.) while D represents the demand for cash over some time. Finally, CH represents the cost of holding cash.
We can re-write the formula above as follow:
C = √(2 x T x F / R)
In the above formula, C represents the optimal cash level. T represents the demand for cash over time. F represents fixed transaction costs for cash transfer. Finally, R represents the alternative cost of maintaining cash.
Example and Calculation
A company, ABC Co., has monthly excess cash inflows of $20,000. ABC Co. intends to invest excess cash in short-term securities. The company expects to earn an interest rate of 6% per annum on the investment. Every time the company invests in securities, the company must bear transaction costs of $100. For ABC Co., the optimal cash level that it can invest in each transaction can be calculated by using the Baumol Model as below.
C = √(2 x T x F / R)
Q = √(2 x ($20,000 x 12 months) x $100) / 5%
Q = √$48,000,000 / 5%
Hence, Q = $30,983
This means that the optimal level of cash that ABC Co. must invest in the securities every time is $30,983.
Drawbacks of The Baumol Model
There are a few drawbacks of the Baumol Model for cash management. First of all, the Baumol model predicts an optimal level of cash. However, in practice, maintaining an optimal level of cash may not be possible. Similarly, the model requires businesses to forecast demand for financial resources. In practice, demands are very difficult to predict and can result in inaccurate results. Similarly, the model requires transaction costs and the costs of holding cash. It may be difficult for businesses to determine these. Furthermore, all these required figures can easily change with time, thus, resulting in inaccurate calculations.
The Miller-Orr Model
The Miller-Orr Model is another model used in the cash management of a business. It depends on establishing different limits for cash.
What is The Miller-Orr Model
The Miller-Orr Model is not concerned with optimal levels of cash like the Baumol Model. Instead, the Miller-Orr Model helps businesses with uncertain or irregular cash flows. It allows businesses to establish an upper and a lower limit for cash balance and determine a target cash balance, which is known as the return point.
Formula
The formula to calculate the return point using the Miller-Orr Model is as below:
Return point = Lower limit + (1/3 x Spread)
We can calculate spread by using the following formula:
Spread = 3 [(3/4 x Transaction cost x Variance of cash flows) / Interest rate] 1/3
The variance of cash flows, required in the formula for spread, is the square of standard deviation in cash flows. Therefore, the variance of cash flows can also be written as:
Variance of cash flows = (Standard deviation in cash flows) 2
Finally, we can calculate the upper limit by using the formula:
Upper limit = Lower limit + Spread
The four steps approach of the Miller-Orr Model
A business must take four steps to use the Miller-Orr Model. These include:
- Establishing a lower limit for cash balances.
- Estimating the standard deviation of daily cash flows.
- Determining the interest rate required.
- Estimating the costs of trading of buying and selling securities.
Once these steps are followed, the Miller-Orr model can be used.
Example and Calculation
A company, XYZ Co., has established a lower cash limit of $50,000. The transactions costs of transferring cash amount to $100 per transaction. The standard deviation in cash flows is $4,000 per day. The interest rate is 11%. First of all, XYZ Co. must calculate the variance of cash flows:
Variance of cash flows = (Standard deviation in cash flows) 2
Variance of cash flows = ($4,000)2
Variance of cash flows = $16,000,000
We can calculate the spread as follows:
Spread = 3 [(3/4 x Transaction cost x Variance of cash flows) / Interest rate] 1/3
Spread = 3 [(3/4 x $100 x $16,000,000) / (11% / 365)] 1/3
Spread = 3 [$1,200,000,000 / 0.03%] 1/3
Hence, spread = $47,622
Now that we have determined the spread, thus we can calculate the return point as follows:
Return point = Lower limit + (1/3 x Spread)
Return point = $50,000 + ($47,622 / 3)
Hence, return point = $65,874
Finally, we can calculate the upper limit as follows:
Upper limit = Lower limit + Spread
Upper limit = $50,000 + $47,622
Hence, upper limit = $97,622
Benefit of The Miller-Orr Model
There are some benefits of using the Miller-Orr Model for businesses. First of all, the model allows businesses to consider cash flows that occur randomly or unpredictably. Second, it considers transfers that take place at any time. Finally, it produces control limits that businesses can use as a basis for cash management.
Limitation of the Miller-Orr Model
There may also be some limitations to using the model for businesses. First, the model is very complicated because it requires different figures that may be difficult to calculate or predict. Second, using the model requires a business to monitor its performance continuously or else the model cannot produce an effective result.
Cash Management Strategies
There are many different cash management strategies that businesses can use to ensure an effective cash management process. The cash management strategy of a business will depend on its cash management policies. First of all, the cash management strategy of a business can include cash flow forecasting. Forecasting cash flows allows businesses to predict any cash flow surplus or deficit and act accordingly.
Similarly, the cash management strategy of a business may include shortening its sales cycles. A sales cycle starts with customers finding a business and ends when they pay for goods purchased. By shortening its sales cycle, a business can accelerate its cash flows. There are many ways to shorten the cycle such as better marketing strategies, faster delivery times or better credit control process.
Finally, the cash management strategy of business also includes understanding the working capital structure of a business. This means understanding all the current assets and current liabilities of a business. Through this, the business can identify any deficiencies within its processes and eliminate them for maximum efficiency.
Cash Flow Management Techniques
The techniques that businesses use to implement cash management strategies or cash management policies are known as cash flow management techniques. Cash flow management techniques mostly involve delaying payments while accelerating receipts. This allows businesses to generate cash surplus or at least match its payments with its receipts. The faster a business can receive its cash flows, the easier it becomes to manage it. Similarly, the later a business pays its obligations, the longer the cash stays within the business.
There are many cash flow management techniques that businesses can adopt to achieve the above. First of all, businesses can offer customers different incentives to encourage early payments. These incentives mainly include offering customers early settlement discounts. Another way to encourage early payments is to set credit limits for customers. If customers do not pay their prior balances, businesses can restrict new sales to them.
Similarly, businesses can also delay payments to implement an efficient cash flow management process. This may include delaying or cutting off unnecessary expenses. Similarly, it may include paying suppliers at the latest possible. Furthermore, businesses can ask suppliers for better payment terms as a part of the business’ cash management strategy.
Another cash flow management technique that a business can use is to keep track of its cash flows. If a business can track its cash flows, it can easily use the information in other cash management processes such as planning. Similarly, a cash flow management technique that businesses can use is to cut out inefficiencies that affect their cash flows. Once inefficiencies are identified, they can be eliminated by the business for better cash flows.
Limitation of Cash Management
There are many limitations to cash management. First of all, it does not consider the accrual concept. This can be problematic as accounting is mainly based on accruals concept rather than cash topic. It also means that the cash management of a business may conflict with its accounting policies.
It also consists of rearranging historical information of a business, which can make it outdated. Reliance on historical data also means that any cash management strategy will not consider any changes in the business environment.
Cash management is also a time consuming and technical work. If a process takes longer to complete, it means that it will increase the costs of a business. Similarly, due to its technical nature, it will require trained individuals to manage it. This may also translate into more cost for a business. For some businesses, the cost may not be justifiable. Sometimes, businesses can use specific cash management tools to their advantage, but there are costs related to these tools as well.
Conclusion
Cash management plays a vital role of any business. Cash management mainly involves managing the cash flows of a business. There are different objectives of cash management such as allowing businesses to plan their cash flows and optimize their cash flows. Cash management can have many functions such as inventory management, receivables management and payables management. Similarly, there are two main models used in cash management namely the Baumol Model and the Miller-Orr model. There are also many different cash management strategies that businesses can use. To implement these strategies business will need to adopt cash flow management techniques.
