Cash management ensures that a business can pay obligations when they fall due without holding more idle cash than necessary. It is a central part of working capital management because too little cash creates liquidity risk, while too much cash reduces profitability.
Why businesses hold cash
Transaction motive
Cash is required for wages, suppliers, taxes, interest and other routine payments when receipts and payments do not occur at exactly the same time.
Precautionary motive
A liquidity reserve protects the business from delayed customer payments, emergency repairs, demand shocks and other uncertainty.
Speculative motive
Available cash lets a company respond quickly to attractive discounts, asset purchases or temporary market opportunities.
Compensating balances
A bank may require the business to maintain a minimum balance as part of its lending or service agreement.
Cash management cycle
- Forecast receipts and payments.
- Set a minimum operating cash balance.
- Accelerate collections without damaging customer relationships.
- Schedule authorised payments efficiently.
- Invest short-term surpluses according to safety, liquidity and return.
- Arrange committed borrowing for forecast deficits.
- Compare actual cash flows with the forecast and investigate variances.
Start with the broader lesson on working capital management.
Cash budget formula and example
A basic cash budget follows this relationship:
Closing cash = Opening cash + Cash receipts − Cash payments ± Financing flows
Assume opening cash is $30,000, expected receipts are $120,000 and expected payments are $135,000. Before financing, closing cash is $15,000. If management requires a minimum balance of $20,000, the business must arrange at least $5,000 of finance or delay a non-critical payment.
| Cash-budget item | Amount |
|---|---|
| Opening balance | $30,000 |
| Receipts | $120,000 |
| Payments | ($135,000) |
| Balance before financing | $15,000 |
| Required minimum | $20,000 |
| Financing need | $5,000 |
Baumol cash management model
The Baumol model applies an inventory-style approach when cash payments occur steadily and cash inflows can be converted from marketable securities as needed.
Optimal transfer amount C* = √(2FT ÷ i)
- F = fixed cost of converting securities to cash
- T = total cash required for the period
- i = opportunity cost of holding cash for the period
If the fixed transfer cost is $50, annual cash use is $1,200,000 and the annual opportunity cost is 8%, the optimal transfer is approximately $38,730. The model is useful for understanding the trade-off between transaction cost and idle-cash cost.
Limitations: the model assumes predictable, steady cash use and does not handle random inflows and outflows well.
Miller–Orr cash management model
The Miller–Orr model is designed for uncertain daily cash flows. Management sets a lower limit, a return point and an upper limit.
- When cash reaches the upper limit, surplus cash is invested to bring the balance back to the return point.
- When cash reaches the lower limit, investments are sold or finance is obtained to restore the return point.
- When cash remains between the limits, no transfer is required.
The model considers transaction cost, cash-flow variance and the opportunity cost of cash. All inputs must use consistent time units.
How to accelerate cash collections
- issue accurate invoices immediately;
- offer convenient digital payment methods;
- use credit checks and appropriate customer limits;
- monitor receivables by age and follow up before accounts become overdue;
- apply economically justified early-payment discounts;
- centralise or automate cash visibility across bank accounts; and
- resolve disputes quickly instead of allowing invoices to remain unpaid.
Collection policy should connect with receivables and creditor management.
How to control cash payments
A business should pay on the agreed due date—not so early that it loses free credit and not so late that it loses discounts, supply reliability or reputation. Useful controls include payment approval limits, segregation of duties, supplier verification, bank reconciliation, duplicate-payment checks and a rolling payment calendar.
Investing short-term surplus cash
The priority order is normally safety, liquidity and then return. Management should match investment maturity to forecast cash needs and consider counterparty risk, price risk, currency risk and early-withdrawal restrictions. Surplus operating cash should not be placed in an instrument that may be difficult to realise when payroll or suppliers must be paid.
Cash management performance indicators
- cash conversion cycle;
- forecast accuracy;
- days sales outstanding;
- days payable outstanding;
- interest earned on surplus cash;
- short-term borrowing cost;
- number of emergency funding events; and
- unreconciled or unauthorised transactions.
Frequently asked questions
What is the main objective of cash management?
To meet obligations on time while minimising idle balances and avoidable financing costs.
What is the difference between profit and cash?
Profit is measured using accrual accounting. Cash reflects actual receipts and payments, so a profitable company can still face a liquidity crisis.
When is the Baumol model appropriate?
When cash usage is predictable and steady, transaction cost is known and surplus funds can be invested.
Why keep a minimum cash balance?
It provides protection against forecast errors, delayed receipts and unexpected payments.
How often should a cash forecast be updated?
That depends on volatility. Many businesses use a rolling 13-week forecast and update the near-term weeks frequently.
Continue learning: review working capital management and inventory and the finance learning path.
The Need For Cash Management.- Making losses.-If a business is continually making losses,it will eventually have cash flow problums.Just how long it will take before a loss-making business runs in to cash flow trouble will depend on. (1). How big the losses are;& (2). Whether depreciation charge is big enough to create a loss dispeite a cash flow surplus.In such a situation, the cash flow troubles might only begin when the business needs to replace fixed assets.
- Inflation.-In a period of inflation, a business needs ever increasing amounts of cash just to replace used-up & worn-out assets. A business can be making a profit in historical cost accounting terms,but still not be receiving enough cash to by the replacement assets it needs.
- Growth.-When a business is growing , it needs to acquire, & to support higher amounts of stocks & debtors. These addition assets must be paid for somehow ( or financed by creditors).
- Seasonlal Business.-When a business seasonal or cyclical sales , it may have cash flow difficulties at certain times of the year, when (1). Cash inflows are low but (2). Cash out flows are high, perhaps because the business is building up its stocks for the next period of high sales.
- One-off Items of expenditure.-The made might occasionally be a single the non-recurring item of expenditure that corrects a cash flow problum, such as (1). The repayment of loan capital on maturity of the debt.Business often try to finance such long repayments by borrowing again. (2). The purchase of an exceptionally expensive item. For example -A small or medium -sized business maght decide to buy a free hold property which then stretches its cash resources for several months or even years.
- Postponing capital expenditure.-It might be imprudent to postpone expenditure on fixed assets which are needed for the development growth of the business.On the other hand , some capital expenditures are routine & might be postponable without serious consequences.The routine replacement of motor vehicles is an example.If a company's policy is to replace company cars every two years ,but the company is facing a cash shortage ,it might decide to replace cares every three years.
- Accelerating cash inflows which would otherwise be expected in a later period.-The most obvious way of bringing forward cash inflows would be to press debtors for earlier payment.Often , this policy will result in a loss of goodwill & problems with customers. There will also be very little scope for speeding up payments when the credit period currently allowed to debtors is no more than the norm for the industry. It might be possible to encourage debtors to pay more quickly by offering discounts for earlier payment.
- Reversing past investment decisions by selling assets previously acquired.-Some assets are less crucial to a business than others & so if cash flow problem are serve, the option of selling investments or property might have to be considered.
- Negotiating a reduction in cash outflows so as to postpone or even reduce payments.-There are several ways in which this could be done,
- Loan replacements could be rescheduled by agreement with a bank.
- A diferral of the payment of corporation tax could be agreed with the inland revenue.Corporation tax is payble nine months after a company's year end.but it might be possible to arrange a postponement by a few months. When this happens , the inland revenue will charge interest on the outstanding amount of tax.
- Dividend payments could be reduced.Dividend payments are discretionary cash outflows , although a company's directors might be constrained by shareholders expectations , so that they feel obliged to pay dividend even when there is a cash shortage.
The Miller-ORR Model.
In an attempt to produce a more realistic approach to cash management,various models more complicated than the inventory approach have been developed.One of these the Miller-ORR model manages to achive a reasonable degree of realism while not being too elaborate.
Advantages & Disadvantages of the Miller-ORR Model.
The usefullness of the Miller-ORR model is limited by the assumptions on which it is based. In practice cash flows & outflows are unlikely to be entirely unpredictable as the model assumes: For example: For a retailer, seasonal factors are likely to affect cash inflows for any company , dividend & tax payments will in advance. However ,the miller-ORR model may save management time which might otherwise be spent in responding to those cash inflows & outflows which cannot be predicted.
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