Management of Cash and Cash Equivalents: formula sheet

Key formulas

Cash equivalent test (AS 3 / Ind AS 7)

Short-term + highly liquid + convertible to known cash + insignificant risk of value change; original maturity normally ≤ 3 months

Equity shares are normally not cash equivalents. Bank overdrafts repayable on demand that form an integral part of an entity's cash management are included as a component of cash and cash equivalents (for the cash flow statement).

Motives for holding cash

Transaction + Precautionary + Speculative (+ Compensating balance)

Name each motive and tie it to the facts in the question.

Core trade-off

Liquidity (ability to pay) versus Profitability (return on funds)

Every objective and policy in cash management balances these two.

Cash management cycle

Forecast → Collect → Pay → Control → Invest surplus

Use this order when asked for the process.

Closing cash balance

Closing cash = Opening cash + Total cash receipts − Total cash payments

The closing balance of one period becomes the opening balance of the next.

Surplus or deficit

Surplus / (Deficit) = Closing cash − Minimum cash balance required

If no minimum balance is given, compare closing cash with zero.

Collection from credit sales

Collection in a month = Σ (Sales of earlier month × % collected after that lag)

Add the cash-sale share of the current month. Use the lag given, such as 1 or 2 months.

Receipt net of cash discount

Cash received = Invoice amount × (1 − discount rate)

Apply the discount only to the portion that is paid early.

Payment to creditors

Payment in a month = Purchases of the month that falls due after the credit period

With one month of credit, this month pays last month's purchases.

Cash expense from total expense

Cash expense = Total expense − Non-cash items (depreciation, amortisation, provisions)

Non-cash items never appear in the cash budget.

Adjusted net income method

Cash flow = Net income + Non-cash charges ± Changes in working capital items

A rough method for longer periods. It is less detailed than receipts and payments.

Raw material holding period

Average raw material stock ÷ Raw material consumed per day

Daily consumption = annual consumption ÷ 365 (or 360 if the question says so).

Work-in-progress period

Average WIP stock ÷ Cost of production per day

If WIP is only partly complete, adjust the cost for the degree of completion as the question states.

Finished goods holding period

Average finished goods stock ÷ Cost of goods sold per day

Use cost of goods sold, not sales.

Debtors collection period

Average debtors ÷ Credit sales per day

Use credit sales. Some questions use sales at cost; follow the question's basis.

Creditors payment period

Average creditors ÷ Credit purchases per day

Use credit purchases of raw material.

Operating cycle

R + W + F + D

R = raw material days, W = WIP days, F = finished goods days, D = debtor days.

Cash conversion cycle

Operating cycle − Creditors' payment period

Also written R + W + F + D − C.

Cash turnover

Days in year ÷ Cash conversion cycle

Number of times the cycle repeats in a year.

Minimum operating cash

Annual cash operating cost ÷ Cash turnover

Exclude depreciation and other non-cash costs.

Baumol optimal cash conversion size

C* = √(2 × U × P ÷ S)

U = cash needed in the period, P = cost per transaction, S = opportunity cost (interest rate) for the same period as U. Keep U and S on the same time basis.

Baumol total cost

Total cost = (U ÷ C) × P + (C ÷ 2) × S

First term is transaction cost, second is holding (opportunity) cost. At C*, the two terms are equal.

Number of conversions and average cash

Conversions = U ÷ C*; Average cash balance = C* ÷ 2

Use C* in rupees, not rounded loosely.

Miller-Orr spread

Spread = 3 × [(3 × P × σ²) ÷ (4 × i)]^(1/3)

P = cost per transaction, σ² = variance of daily net cash flows, i = interest rate per day. Take the cube root of the whole bracket.

Return point and upper limit

Z = L + Spread ÷ 3; H = L + Spread = 3Z − 2L

L is the lower limit set by management. Z is one-third of the spread above L.

Miller-Orr average cash balance

Average cash balance = (4Z − L) ÷ 3

Equivalent to L + 4 × (Z − L) ÷ 3.

Yield on a discount instrument (simple, not annualised)

Return for the period = (Face value − Purchase price) ÷ Purchase price

T-bills, CP and CDs are issued at a discount, so the gain is face value minus issue price. Divide by the amount you actually invest.

Annualised yield

Annualised yield = [(Face value − Price) ÷ Price] × (365 ÷ Days to maturity) × 100

Use 365 days unless the question says 360. This is simple annualisation. Use it to compare instruments with different maturities.

Discount rate (bank discount) basis

Price = Face value × [1 − (Discount rate × Days ÷ 365)]

When a question quotes a discount rate, the effective yield is higher than the quoted rate because the investment is the lower price.

Effective annual yield (compounded)

EAY = (1 + Period return)^(365 ÷ Days) − 1

Use only if the question asks for compounded or effective yield.

Selection rule

Safety → Liquidity → Maturity match → Yield

Rank in this order. Choose the highest yield only among options that pass the earlier tests.

Quick revision

• Three motives for holding cash: transaction, precautionary and speculative.
• Holding too much cash loses return; holding too little risks inability to pay.
• A cash budget shows receipts, payments, closing balance and any financing needed or surplus.
• Non-cash items like depreciation are left out of a cash budget.
• Operating cycle = inventory period + receivables period.
• Cash cycle = operating cycle − payables period.
• A shorter cash cycle means a lower cash need for the same sales.
• Baumol model treats cash like inventory and balances transaction cost against holding cost.
• Baumol assumes steady cash use and no cash receipts during the period.
• Miller-Orr model suits uneven cash flows and uses a lower limit, a return point and an upper limit.
• Money market instruments are short-term, liquid and low risk, such as treasury bills, commercial paper and certificates of deposit.
• Match the maturity of an investment with the date you will need the cash.

Common mistakes

• Treating all short-term investments as cash equivalents. Fix: Apply the full test. A 6-month deposit at purchase is not a cash equivalent, even if only 1 month remains.
• Confusing precautionary and speculative motives. Fix: Precautionary protects against bad surprises. Speculative exploits good surprises.
• Including depreciation as a cash payment Fix: Underline any non-cash item in the question and deduct it from overheads before putting the figure in the budget.
• Showing sales and purchases in the month of the transaction instead of the month of cash movement Fix: Ask for every item: in which month does the cash actually move? Use the credit period and the collection pattern to place it.
• Using total sales for debtors' days when credit sales are given. Fix: Read the question for credit sales. Use total sales only if no split is given, and say so.
• Dividing finished goods stock by sales instead of cost of goods sold. Fix: Stocks are valued at cost, so match them with cost flows: consumption, cost of production, cost of goods sold.
• Using an annual interest rate with a daily variance in Miller-Orr. Fix: Convert the rate to a per-day rate using the days stated in the question before using the formula.
• Taking the cube root only of part of the Miller-Orr bracket, or using a square root. Fix: Baumol uses a square root. Miller-Orr uses a cube root of the whole bracket (3Pσ² ÷ 4i), then multiplies by 3.
• Dividing the gain by face value instead of the purchase price. Fix: Money invested is the price paid. Always divide by price.
• Forgetting to annualise when comparing instruments of different maturities. Fix: Multiply by 365 ÷ days before comparing.

Exam tips

• MCQs usually give a short situation and ask for the motive. Practise matching keywords quickly.
• In written answers, write each motive as a separate bullet with an example. This earns step marks.
• If asked about cash equivalents, always mention the three-month original maturity condition.
• For objectives questions, write both liquidity and profitability. One-sided answers lose marks.
• Link this topic to cash budgets and the Baumol and Miller-Orr models, which are tested numerically.
• Show a clear working note for collections and for creditors payments. Examiners give step marks for these even if the final balance is wrong.
• Read every note in the question for non-cash items, one-time payments and different payment lags, because these are the usual traps.
• Always carry forward the closing balance as the next month's opening balance and show it on the page.