Cash Management – What Is Optimal Cash Balance?

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Financial managers are responsible for cash management. This responsibility demands that the financial manager maintains adequate balances of cash and marketable securities. And also see to the efficient operation of cash management at the lowest cost possible.


What are cash and marketable securities?

Cash is the currency on hand and in the demand deposit (checking account) balances maintained at the bank.
Marketable securities are short term securities ranging from overnight loans to maturities of less than a year. They are securities that are quickly converted to cash.

The financial manager has a job to establish optimal cash balances that minimizes idle cash balances that earn nothing and also maintain sufficient cash balances that meet anticipated and unanticipated cash needs.

Before the financial manager could establish optimal cash balances successfully, they have to examine the following considerations and costs:

  1. Select a planning timeframe within which to estimate cash inflows and cash outflows expected to occur expected to occur in each sub period within the time frame. This would require the construction of a cash budget with a forecast on the collection of accounts receivable,

2. The cash budget should be constructed to predict times when shortfall could be expected. This is important because every shortfall incurs costs. These costs could be transactions costs associated with raising cash. Or they could be costs associated with deteriorating credit rating.

3. There are also costs associated with having excessive cash balances. Too much idle cash is a indication of missed investment opportunities. Ideally, every fund should be invested, if only temporarily, at a positive rate of interest.

4. The impact of uncertainty on cash management strategy should never be overlooked. To minimize the impact, an improved forecasting and cash flows that give the financial manager control and increased ability to borrow are necessary.

How does the financial manager determine the cash need (an optimal cash balance)?

There are three approaches:

  1. The Cash budget,
  2. Minimizing-cost model and,
  3. Precautionary balances.

  1. The Cash Budget:

A cash budget is one of the most important budgets prepared in an organization. It is a summary of expected cash receipts and expected cash payments during the budget period.

The consideration of liquidity and cash management as key factors in an organization’s successful operation makes cash budget very important.

Cash budget is the financial manager’s fundamental tool for coordinating and forecasting cash flows. The cash budget shows the effect of budgeted activities, such as cash sales, buying, accounts receivable collections on the cash flow of a business. There are no accruals in the cash budget.

Once estimated cash receipts and expenditures are known, the possibility of having an unexpected shortfall is easily increased.

2. Minimizing- cost model:

The cash budget does not show how the optimal cash balance is arrived at. The job of a good financial manager is to minimize a business’s cost of maintaining cash balances.

For this to be achieved, the financial manager must recognize and minimize the three basic cost categories of short costs, excessive cash costs and procurement costs.

Short costs rise as a business holds less and less cash. On the other hand, long cost (costs incurred for holding idle cash and missing investment opportunities) increases as the idle balances increase.

Another cost that must be considered is the procurement costs associated with operating the cash management system. These are salaries and wages for staff of the cash management unit including overhead of the unit. These costs are fixed.

Now, how are total cash management costs calculated?

Recall that total cash management costs (TC) are made up of;

Procurement costs – P,
Total Short Costs – TSC,
Total Long Costs – TLC

Therefore TC = P + TSC + TLC.

3. Precautionary Cash Balances:

The financial manager has to also determine how much more money to hold in addition to the optimal cash balance. The financial manager has to go back to the history of the business to know what it did when it encountered an unexpected cash need above the optimal balance.

The manager would also have to determine the cost of not having precautionary balances to meet unexpected cash needs.

There are benefits for having precautionary balances. Profit opportunities may suddenly present themselves and a business with precautionary balances would avoid costs associated with the inability to raise cash to meet sudden cash needs.

But there is also a cost for having precautionary balances. One may be forfeited interest that could have been earned if those cash balances were invested.

Therefore, there is need to estimate an optimal level of precautionary cash balances.

Determining the optimal level requires a costs-benefits approach to find where total net profits (benefits minus costs) are maximized.

The benefits (B) could be assumed to be the following:

  1. The average return on the expected profit opportunity – R,
  2. Precautionary Cash Balance level – PCB and,
  3. The fraction of the year over which the opportunity occurred – N.

Therefore, B = R x N x PCB.

The cost (C) of the precautionary balances for the year could be assumed to be:

  1. The forfeited yield on securities for the period held and,
  2. Precautionary Cash Balance level – PCB.

Therefore, C = Y x PCB.

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