Page 113 - DCOM505_WORKING_CAPITAL_MANAGEMENT

Working Capital Management

Notes Self Assessment

Fill in the blanks:
4. ............................ refers to the movement of cash into and out of a business.
5. The inflow includes the cash you receive from ............................ , ............................ and
............................
6. If its cash ............................ exceeds the ............................ , a company has a positive cash flow.
7. A ............................ shows the sources and uses of cash.

7.3 Factors Determining the Optimum Cash Balance

A firm has to maintain a minimum amount of cash for settling the dues in time. The cash is
needed to purchase raw materials, creditors, day to day expenses, dividend, etc. The test of
liquidity of the firm is that it is able to meet various obligations in time.
Some cash will be needed for transaction needs an amount may be kept as a safety stock. An
appropriate amount of cash balance to be maintained should be determined on the basis of past
experience and future expectations. If a firm maintains less cash balance then its liquidity position
will be weak. If higher cash balance is maintained then an opportunity to earn is lost. Thus a firm
should maintain an optimum cash balance, neither a small nor a large cash balance. For this
purpose the transaction costs and risk of too small a balance should be matched with the
opportunity costs of too large a balance.
The factors that determine the optimum cash balances are:
1. Synchronization of cash flows

2. Short costs
3. Excess cash balance
4. Procurement and management
5. Uncertainty.

1. Synchronization of cash flows: The need for maintaining cash balances arises from the
non synchronization of the inflows and outflows of cash: if the receipts and payment of
cash perfectly coincide with each other, there would be no need for cash balances. The first
consideration in determining the cash balances is hence the extent of synchronization of
cash receipts and disbursements. For this purpose, the inflows and outflows have to be
forecast over a period of time depending upon the planning horizon which is typically a
one year period with each of 12 months being a sub-period. The technique adopted is a
cash period. A properly prepared budget will pinpoint the month/periods when the firm
will have an excess or a shortage of cash.
2. Short Costs: The other most important factor in determining the optimum cash is the
shortfall in cash needs. The cash forecast as presented in the cash budget would reveal cash
shortage periods. Despite this, there may be some additional shortfall. Every shortage of
cash whether expected or unexpected involves a cost depending upon the severity, duration
and frequency of the shortfall and how the shortage is covered. Expenses incurred as a
result of shortfall are called short costs.

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