# (Relevant to PBE Paper II Management Accounting and Finance) Eric Y.W. Leung, CUHK Business School, The Chinese University of Hong Kong

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2 The objectives of cash management are therefore two-fold: (i) to have sufficient cash for operation in order to maintain liquidity; and (ii) to invest excess cash for a return. Cash management is not easy. Cash inflows from receipts do not perfectly coincide with the cash outflows for disbursements. Further, some businesses are seasonable in nature so that cash inflows and outflows fluctuate throughout the year. The company therefore needs to manage its cash properly. One of the tools it can use to do this is to prepare a cash budget. Cash Budget A cash budget is a statement showing the estimated cash inflows and outflows over the planning horizon. Companies can prepare a cash budget on a quarterly, monthly, weekly or even daily basis. The ultimate purpose is to identify the net cash position of the company in the future, that is, whether there is any cash surplus or deficit. Preparation of a cash budget is an indication of good planning. If such a budget is not prepared, the company runs the risk that if unfortunately it is in sudden need of cash, there may be insufficient time for the company to search for alternative source of financing, forcing it to accept funding which is more expensive. After identifying the net cash position of the company in the future, the next question is then how the company manages its cash surplus or deficit. Miller-Orr Model In order to manage its cash balance, the company can employ a mathematical model, one of which is the Miller-Orr model. The Miller-Orr model helps the company to meet its cash requirements at the lowest possible cost by placing upper and lower limits on cash balances. The operation of the model is as follows: (i) A company should have its desired cash level, an upper limit and lower limit on cash balances. (ii) When the cash balance reaches the upper limit, the company has too much cash. It then should use its cash to buy marketable securities in order to bring the cash balance back to its desired cash level. (iii) When the cash balance hits the lower limit, the company lacks cash. It then sells its securities in order to bring the cash balance back to its desired cash level. (iv) If the cash balance lies between the upper and lower limits, there will be no transaction in securities. 2

3 The Miller-Orr model increases its practicability by incorporating an assumption that cash balances randomly fluctuate and therefore are uncertain. The formula in determining the desired cash level is as follows: where z = desired cash level F = fixed transaction cost of buying and selling marketable securities σ 2 = variance of daily cash flows (which indicates its randomness) r = daily interest rate on marketable securities L = minimum cash balance The upper limit cash balance is then determined as: Example: Sweets Ltd. wants to maintain a minimum cash balance of \$500,000. The estimated variance of the daily cash flows is \$1,200,000 per day and the cost for each transaction of buying and selling marketable securities is fixed at \$10,000. The marketable securities yield 3% per year. Sweets Ltd. wants to use the Miller-Orr model to determine its desired cash balance. Sweets Ltd. s desired cash level is: The upper limit for Sweets Ltd. s cash balance is: The decision rule by the Miller-Orr model is then as follows: (i) Sweets Ltd. should set the desired cash balance at \$547,356. (ii) When the cash balance reaches the upper limit of \$642,068, Sweets Ltd. has too much cash. It then should use its cash to buy \$94,712 (\$642,068 - \$547,356) marketable securities in order to bring the cash balance back to its desired cash level (i.e. \$547,356). 3

4 (iii) When the cash balance hits the lower limit of \$500,000, the company lacks cash. It then sells \$47,356 (\$547,356 - \$500,000) of its securities in order to bring the cash balance back to its desired cash level (i.e. \$547,356). (iv) If the cash balance lies between the upper and lower limits (i.e. between \$500,000 and \$642,068), there will be no transaction in securities. (Note 1: The return (r) used in the Miller-Orr model represents daily return. If the given return is annual interest rate, remember to divide it by 365 (number of days in the year) to obtain the daily interest rate.) (Note 2: The desired cash level and the upper limit of cash balance are affected by three factors: (i) fixed transaction costs; (ii) variance of cash flows; and (iii) interest rate of marketable securities as return.) (Note 3: Students are advised to visualize the above decision rule graphically.) It should be noted that the Miller-Orr model is a theoretical model. It however sheds light on how the company can manage its cash balances. Recall that the Miller-Orr model requires selling and buying marketable securities. The next section discusses some of the features of marketable securities. Investing Idle Cash It is not uncommon to have cash surplus, especially for businesses with seasonal or cyclical activities. If the company has a temporary cash surplus, it can consider investing its excess cash in marketable securities in money market, which is defined as the market for short-term financial assets. Normally, the company needs to take into account the following criteria in determining such investments: (i) Maturity: Maturity refers to the time period over which interest and principal payments are made. The company should consider the maturity of investments with reference to its cash budget, in particular how long the company has a cash surplus and when the company will need money for its expenditure. Normally, the maturity period for marketable securities will be less than three months. (ii) Default risk: Default risk refers to the probability that interest and the principal will not be paid in the promised amount on the due dates. The company should avoid investments with high default risks as an investment for its idle cash. The investments should be safe enough to provide cash for future payments. 4

5 (iii) Marketability: Marketability refers to how easy it is to convert the financial assets to cash. The company should minimize the amount of time required to convert the securities into cash. Conclusion Cash is important to every organization. It is critical for companies to hold cash for payments but at the same time avoid holding excess cash, as this is a non-earning asset. Cash management is therefore a balance between liquidity and profitability. Companies are strongly advised to prepare a cash budget to highlight the net cash position in the future and devise its cash management strategies with reference to the Miller-Orr model. Students are reminded that cash management is a concept within working capital management. The proper management of cash is part of various working capital management methods such as factoring accounts receivables at banks to get immediate cash and offering discounts to customers to encourage early collection. Students therefore need to think broadly and link various concepts together in order to provide a better solution in the examination. 5

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