Cash is basic input to start a business unit. Cash is initially invested in fixed assets like plant and machinery, which enable the firm to produce products and generate cash by selling them.
Cash is also required and invested in working capital. Investments in working capital are required because firms have to store certain quantity of raw materials and finished goods and provide credit terms to the customers.
What is Cash Management
In the context of working capital management, cash management refers to optimizing the benefits and costs associated with holding cash. In other words, the demand for cash is affected by several factors and some of them are within the control of the managers and others are outside the control of the managers.
Motives of holding cash
Fixed assets are used to convert the raw materials into finished goods. Investment in current assets cannot be avoided due to constraints in technology, manufacturing process and customers’ behavior of demanding.
Firm is not dependent on this asset in manufacturing process nor is required for creating inventory or selling. Thus the basic question is why firms hold cash and marketable securities.
Some of the reasons for holding cash are listed below.
- Transaction Motive
- Precautionary or Hedging Motive
- Speculative Motive
- Managing uneven supply and demand for cash
Money is required to settle customers bills, pay salary and wages to workers, pay duties and taxes, etc. some cash balance is to be maintained to complete these transactions. The amount to be maintained for the transaction motive depends on the cash inflows and outflows.
Precautionary or Hedging Motive
The transaction motive takes into account the routine cash needs of the firms. It is also based on the assumption that inflows are as per estimation. However, the future cash needs for transaction purposes are uncertain.
The firm has to protect itself from such contingencies by holding cash balance. This is called as precautionary motive of holding cash balance. Precautionary cash balance is also maintained to meet the non-routine needs.
Generally, cash required for precautionary motive is held in the form of short-term securities with the objective to earn atleast some positive return.
The term speculative motive to some extent is a misnomer since cash is not kept to conduct any speculation but merely to exploit opportunity. This is particularly relevant in commodity sector, where the prices of material fluctuate widely in different periods and the firm’s business success depends on its ability to source the material at the right time.
Managing uneven supply and demand for cash
Firms generally experience some seasonality in sales, which leads to excess cash flows in certain period of the year. This is not permanent surplus and cash is required at different points of time.
One possible solution to address this mismatch of cash flows is to pay off bank loans whenever there is excess cash and negotiate fresh loans to meet the subsequent demands.
Determinants of Cash Flows
Investments in cash and marketable securities depend on the cash flow of the firm. Firm in a competitive industry which have to extend credit to the customers need to maintain large amount of cash to meet different motives of holding cash.
Cash flows are also affected by several other factors, which can be broadly classified into internal and external factors.
Internal factors relate to policies of management relating to working capital components and future growth plan. These factors are determined by the firm and arising out of management decisions.
The internal factors that affect the cash flows of firms are below.
- Production-related Policies
- Policies on Discretionary Expenses
- Policies on Receivable
- Financial Policies
- Payment Policies
External factors can be broadly classified into monetary and fiscal factors and industry-related factors. These are below:-
- Monetary and Fiscal Factors
- Industry-related factors
Objectives of Cash management
Cash flow forecast is crucial in cash management. Thus, the efficiency of cash management is directly related to the ability to accurately forecast cash flows. Recognizing and managing cash flow variation is thus another important issue in cash management.
These are several methods through which firms recognize and manage the uncertainty associated with cash flow variation.
- Sensitivity analysis
- Scenario analysis
- Simulation analysis
- Holding a stock of extra cash or Near-cash asset
- Extra Borrowing Capacity
- Using Interest-Rate Derivatives
The impact of changes in cash flow variables on cash balance is examined through sensitivity analysis. This objective of the analysis is to determine the most sensitive cash flow variables that will place the cash management in a difficult position.
This information is useful to evaluate the possibility of cash flow variable affected to that extent, plan to ensure that the cash flow variable is within the normal limit and prepare a contingency plan.
Here cash flows are forecasted under different assumptions and cash requirement under different scenarios is worked out. Depending on the level of risk taking capability, firm selects a scenario and uses it for cash management.
It is an extension of scenario analysis. In scenario analysis, the user defines possible scenarios and the computers generate the cash forecast. In simulation, the computer is allowed to generate various scenarios based on random numbers.
Holding a stock of extra cash or Near-cash asset
This is the simplest solution to manage the uncertainty associated with the forecasting of cash flow. This is relied upon when the level of uncertainty is high.
Extra Borrowing Capacity
If the uncertainty analysis model helps to figure out the period in which the firm is likely to face serious problem of cash management, then it is worth to negotiate with bankers or other financing agencies well in advance for additional temporary credit.
Using Interest-Rate Derivatives
If uncertainty in cash flows is on account of expected changes in the interest rate affecting the interest income or interest payments, the interest-rate derivatives such as interest rates futures and interest rate options are useful to manage this part of risk.
At last words of this article cash is also required because and invested in working capital. The firm needs additional cash during its life whenever it needs to buy more fixed assets increase the level of operations and any change in working capital cycle such as extending credit period to the customers.
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