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Working capital management – Cash and funding strategies

Cash management models

3.1 Overview

Cash management models are aimed at minimising the total costs associated with
movements between:

 a current account – very liquid but not earning interest (making profit)

 short-term investments – less liquid but earning interest

3.2 The Baumol cash management model

Baumol noted that cash balances are very similar to inventories, and developed a
model based on the economic order quantity (EOQ) inventory model.

2Co.D
Q=
Ch

Where:

Co = the brokerage cost of making a securities trade or borrowing

D = the total amount of net new cash needed for transactions over the entire period,
or the excess cash available to invest in short term securities

Ch = opportunity cost of holding cash (equals the rate of return generated by
marketable securities or the cost of borrowing in order to hold cash).

This model is most useful when cash balances move steadily in one direction over
time.

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