15 minute read
Masterclass
Cashflow management
Never more in recent history has the monitoring of cashflow been more important and of a critical focus for businesses.
Cash, as opposed to other current asset
management is a subject that has attracted considerable attention of late.
In this article we touch on the major factors to be considered in the management of cash within a business.
Cash management is an awkward topic to deal with in such a general way because its application is applied across a very broad spectrum – from a sole trader to a large multi-national corporation. It is therefore vital to use a cost-benefit framework when assessing the applicability of some of the mathematical or computer dependent cash management techniques.
We also refer to some of the models that have been developed to assist in the cash management process.
1. Importance of Cash Management The necessity for effective cash management can be gauged by the penalties paid by firms that have neglected to do so. In the extreme case, the result can mean insolvency.
In the lesser case, the results are reduced returns, either due to lost opportunity for investment of idle funds, or as a result of increased costs (e.g. loss of discounts, use of expensive means of financing) or a combination of factors.
Interest rates impact the return on an investment, the required rate of return and the opportunity costs.
l Increasing Opportunity Costs Interest rates and the cost of money reduce the return and therefore have an opportunity cost.
l Inflation The effects of inflation on the levels of inventories and receivables and thus on working capital requirements generally, have placed significant pressure on liquidity in most businesses. This problem is not recognised by our taxation system.
2. The need for Cash The reasons for holding cash can still be analysed along the lines suggested by Keynes almost 100 years ago. That is, cash for transaction purposes, and cash for provision of precautionary reserves.
Cash balances are required for transactions that is the day to day, month to month operation of the business, primarily because it is highly unlikely that the business will be able to arrange exact synchronisation between cash inflow (from sales) and cash outflows (for purchases of inventories and payment of expenses).
Cash balances of a precautionary nature are required because of the uncertainty involved in much of the business’ forward planning.
Two major problems of cash management may be summarised as: (a) Ensuring the funds are available to meet those situations where cash outflows exceed cash inflows (e.g. by use of an overdraft, short-term accommodation, extending of payment, etc). As an adjunct to this, if finance would not appear to be available, it would be necessary to ensure that suitable action is taken to avoid the situation, perhaps by re-arranging receipts and payments schedules or moving to a less ambitious scale of operations.
To put this another way, firms should subject planned activities to cash flow analysis to gain an idea of potential problem areas before committing themselves to action. (b) Ensuring that surplus cash made available when inflows exceed outflows is placed to the best advantage (e.g. reduction of overdraft, short-term investment, retirement of debt, financing of longterm investments, etc).
3. The process of Cash Management Effective cash management involves three steps –(a) Determine the levels of cash required for transactions at different intervals over specific time horizons. (b) Determine the precautionary cash balances required.
The level of a firms “safety margin” will depend on the stability and predictability of the key variables –e.g. sales and operating expenses. (c) Determine the optimum funding/investment methods to meet the requirements of (a) and (b). Before examining each of these steps in detail, it is poignant to touch on two areas which are often overlooked.
Firstly, the quicker a business can convert its revenue into cash in the bank, the lower is its requirement for intermediate financing. It follows then that it is important to closely examine areas such as credit policies, cash collections and banking methods.
Secondly, the longer the delay in converting liabilities or other commitments into cash payments, the lower the need for financing. The businesses accounts payable, wages and general payment procedures should be examined.
In looking at the business’ policies in these areas, it is important to recognise all of the opportunity costs and ramifications involved, (viz. the effects on sales, credit worthiness, relations with bankers and so on), as well as the more easily identifiable costs and benefits.
4. Cash Flow Forecasts The development of the cash flow forecast, for any time horizon will start with projections of income and expenditure, together with estimates of other flows such as capital investments, payment of taxes, repayment of loans and so on.
It is usually at this time that the first setback in cash management occurs. Despite the exhortations of generations of teachers of the management sciences, there are a great number of businesses which do not attempt to finalise operational and financial planning.
Normally the planning framework could be broken down into long-term, medium-term and short-term. (This could be five (5) years and over, one-five years and under twelve months respectively). The medium and long-term plans will usually be concerned with aggregate levels, based on estimates of net income adjusted for the non-cash items, and balance-sheet items. This is referred to as the top-down approach.
The planning horizon the business is usually most concerned with is the short-term one. This period may be broken down into smaller periods. One such set of subperiods could be: — Daily for the first four weeks — Weekly for the next two months The development of the cash flow forecast, for any time horizon will start with projections of income and expenditure, together with estimates of other flows such as capital investments, payment of taxes, repayment of loans and so on.
— Monthly for the next three months — Quarterly for the next six months
These short-term forecasts should be based on detailed operating budgets and should follow the “bottom-up” approach – i.e. building the final picture by working up from the detail level.
The questions of how detailed is the breakdown and how short is the time period can only be judged on a cost benefit basis – i.e. what are the costs (clerical, computer and administrative) of obtaining short term detail, and what are the benefits in terms of better control and more effective use of funds.
From the detailed operating budgets, and estimates of non-operating cash items, a detailed cash forecast can be established.
Several things emerge quickly when actually sitting down and preparing a cash budget.
Firstly, cashflow timings are not the same as revenue account timings – e.g. sales may be either cash, or credit, or a combination of both. In the case of credit sales, the actual receipt of the cash will depend on the business’ credit policy.
Secondly, in estimating cashflows, we are assuming that the policies in areas such as credit and accounts payable are fixed, as is the timing of say, capital investment outlays. By making assumptions about these policies the business can prepare the cash flow estimates. It should be recognised however, that these policies can be changed in order to determine the optimum solution to the cash management problem. Orgler has examined this problem, and refers to the “sequential” approach and the “simultaneous” approach.
The Sequential approach takes all other policies as being given, and solves the cash budget problems by examining the effect of the surplus or deficit for each period on that period’s closing cash balance, and either borrowing or investing as the case may be.
The Simultaneous approach however, recognises that short term cash flow problems may be solved ➤
by changing other variables, e.g. postponing capital outflows, or deciding not to take settlement discounts in one period etc. (Each one of these actions would have its own cost/benefits, which would need to be evaluated).
5. Precautionary Cash Balances Having established the cash flow forecast, the next step is to carry out sensitivity analysis i.e. to determine the possible variability of results from the estimates.
It is likely that in estimating the underlying variables (e.g. sales, inventory purchases, and other cash flows) it has been necessary for the business to use mean values – i.e. the business has used the most likely values, given its experience with the behaviour of the variables.
Having obtained some idea of the possible variability of the cash flows, the desired level of the precautionary cash balance can be determined. An important factor in establishing this level will be the attitude of individual management to the risk of running out of cash, and the alternative sources of cash available. These sources may include unused overdraft limits, a line of credit via a bill discounting facility, access to short term loans etc.
6. Optimisation of Cash Balances The earlier sections have provided the foundations for cash management. If a business were to follow these methods, then all other things being equal, the chances of insolvency due to inadequate cash management should be greatly reduced. It should be stressed that cash management cannot reduce normal business risk and no claims are made in this regard.
The next problem is to determine how periodic deficits will be funded, and surpluses invested.
It is not the intent to detail specific types of finance or investments, but rather to deal with some optimisation methods which have been proposed. The selection of the appropriate source of use of funds will depend on the specific costs and benefits applicable to the business at the time, taking into account relative interest rates, transaction costs, risks, credit worthiness and so on.
7. The Sequential approach – Optimisation models Briefly recalling that the Sequential approach to cash management determines the periodic surplus/deficit with the effect of this result on the business’ cash balances on a period by periodic basis.
As mentioned earlier, cash balances are comprised of the result of the firm’s periodic operations, plus the required safety margin (i.e. the transaction and precautionary cash needs).
Having made these decisions, the question is then how to hold this balance – e.g. all cash, all
unused overdraft limit, all short term investments, or combinations of these and others.
If the firm holds cash there are opportunity costs involved. If it holds short term investments there are transaction costs involved. If it relies on unused overdraft limits, there are costs (both actual and opportunity) involved.
Several mathematical models have been proposed to provide the optimum solution to this problem. Some of these will be detailed below.
Before commenting on them, we pass some general comments concerning models.
A mathematical model seeks simply to incorporate the variables of a problem into a functional relationship, which will allow consistent solutions to be calculated for changing variables.
In doing this, the model cuts through the often imprecise language definition of the problem, and seeks to come to grips with the Key Factors. So far so good. To obtain the precision necessary for the mathematical expression, the model must make assumptions about the behaviour and relationship of these Key Factors, and it is here that we come to the major criticism of many models.
The effectiveness of a model should not be judged by the simplifying assumptions made, but by how well it predicts real life behaviour. If the model accurately and consistently predicts actual observations, then in the absence of evidence to the contrary, it is a good model. If the model does not work, then either the functional relationship itself is wrong, or the simplifying assumptions have made it too restrictive for the real world. The other criterion for the usefulness of a model is its cost effectiveness.
Reasons supporting the use of models include: — Identification of costs and benefits — Formalisation of cost benefit trade-offs — Formalisation of procedure — Provision of a performance yardstick
(a) Inventory Based Models
Much of the initial work on optimum cash levels made use of the economic order quantity inventory models.
These models seek to provide solutions to: — The minimum and maximum levels of cash
The minimum and maximum levels of marketable securities When to transfer between marketable securities and cash The costs of a cash “stock-out” and the trade off between this cost and the cost of holding cash.
The E.O.Q. model, where the inventory item is cash flowing out at a constant rate, and being replenished at specific intervals in equal amounts by sale of securities, or borrowing. Thus, cash flows are known and are constant, and the only variables are the relative interest rates and the (fixed) transaction costs. The followingCash Balance demonstrates graphically the workings $ of C the basic model.
Simple Inventory Based Cash Management Model
(Baumol)
Cash Balance Time
B = fixed cost per conversion T = total cash outflows for the time span under consideration I = the interest rate per period Note: 1) As T increases, so too does C, but at a smaller rate. 2) washes out effects of estimating errors.
A major problem with this model and its developments is that although there may be some firms whose cash flows are in accord with the underlying assumptions, there is limited general applicability.
In an attempt to overcome the limitations of constant or known cash flows, another model was developed.
C
(b) Stochastic (random cash-flow) Model
This model seeks to overcome the problem of limiting assumptions by developing a model based on randomly fluctuating daily cash flows.
The purpose of the model is to set control or decision limits which balance the opportunity costs of holding cash with the transaction costs of converting to and from securities. The following graph outlines the working of this model.
Stochastic Cash-Management Model
(Miller Orr)
h
Cash Balance
Cash Balance z
0
Time
When c = optimum cash conversion size
h
L
Z =
z
L = 3Z Z = optimum cash re-order level B = transaction cost (fixed) 02 cB = variance L of daily changes in cash balances I = daily interest rate (opportunity cost) H = upper control limit L = lower control limit
Note 1: when the cash balance reaches L, buy L-Z securities, which will return the cash balance to Z. Note 2: when the cash balance reaches L, sell Z-L securities, which will return the cash balance to Z. Note 3: washes our effects of estimating errors.
Two important assumptions of this basic model are: — Firstly, that the cash flow pattern is random, and secondly, that adjustments necessary are between cash and marketable securities. The first assumption means that significant known flows such as capital investment, dividends, ➤
tax payments and the like, should be handled outside the model, and the latter assumption has been varied in later adaptions of the model. Miller and Orr were quite well aware of the simplifications they had introduced in their model, and to test its usefulness, they ran tests of the model in an actual cash management environment. The results are encouraging in that the model’s performance showed improvement on existing management technique.
8. Simultaneous Approach Model One of the assumptions of the sequential approach to optimising cash balances is that other factors are constant – e.g. that accounts receivable and accounts payable policy is fixed.
Another assumption is that while optimisation in successive periods will be dependent on decisions made in the current period, there is no attempt to consider inter-period effects, and look at optimisation over the entire time horizon, perhaps by shifting flows between periods where this is possible.
One method has been proposed to deal with decision making over a number of variables within the current period and also to deal with inter-temporal aspects of cash management.
In this method, using multi-period linear programming, cash management decisions for all periods within the time-horizon are optimised, taking into account multiple solutions for each sub-period.
For each sub period the estimated cash flows are calculated by the solution to the funding of any deficit would include consideration of changing current policies e.g. with respect to accounts receivable and accounts payable, or timing of capital investment, as well as the more usual model solutions involving use of overdraft or other sources of short term finance. Similar considerations would be included in respect of periodic surpluses.
The advantages of this type of model are those of being able to consider multiple factors and time period effects in optimising the solutions, and also the
additional information provided by the dual model in evaluating the marginal effects of the constraints. The disadvantages of this method are firstly the determination of the objective function for the linear programming model and secondly the costs of estimating the range of values for the function and finally the processing costs involved.
9. The Costs and Benefits of Models There is no doubt that the application of scientific method to cash management does have potential for improving efficiency and overall performance.
However, those models which require only limited data collection or estimation suffer from the problem of having very little real life application. On the other hand, while it is possible to tailor models to the specific requirements of a firm, this is usually achieved in conjunction with high data collection and processing costs. For large firms though, with significant funds in the balance, the prospective rewards could provide incentive to develop specifically tailored models.
10. Conclusion Effective cash management is an important component in the portfolio of skills required by credit professionals. Appropriate application of cash management techniques is surely one of the most basic ingredients for survival and success for any business.
Reprint of previous article in Australian Credit Management with amendments.
Another assumption is that while optimisation in successive periods will be dependent on decisions made in the current period, there is no attempt to consider inter-period effects, and look at optimisation over the entire time horizon, perhaps by shifting flows between periods where this is possible.
