The economic-order quantity (EOQ) formula, basically used in inventory decision, has now come to be popularly employed to determine the optimal level of cash holding for the firm. William Baumol was the first man who applied the inventory model to the problem of cash management.
According to the EOQ model, optimum level of cash should be determined by balancing the carrying cost of holding cash (the interest foregone on marketable securities) against the fixed cost of transferring marketable securities to cash or vice-versa so as to minimize total costs. The level of cash at which the sum of inventory carrying costs and the fixed costs associated with transferring marketable securities is minimum, will be the optimum cash balance of the firm. The following formula is used to determine has optimum level:
Q = √2GB/K
Q = stands for optimum size of cash inventory.
C = stands for average fixed cost of securing cash from market.
B = stands for the cost of carrying the inventory of cash i.e., interest rate on marketable securities for the period.