Cash management is the process of forecasting, collecting, disbursing, investing, and planning for cash a company needs to operate smoothly. Cash management is a vital task because it is the most important yet least productive asset that a small business owns. A business must have enough cash to meet its obligations or it will be declared bankrupt. Creditors, employees and lenders expect to be paid on time and cash is the required medium of exchange. However, some firm retain an excessive amount of cash to meet any unexpected circumstances that might arise. These dormant cash have an income-earning potential that owners are ignoring and this restricts a firm’s growth and lowers its profitability. Investing cash, even for a short time, can add to company’s earning. Proper cash management permits the owner to adequately meet cash demands of the business, avoid retaining unnecessarily large cash balances and stretch the profit generating power of each dollar the business owns.
Cash management is particularly important for new and growing businesses. Companies suffering from cash flow problems have no margin of safety in case of unanticipated expenses. They also may experience trouble in finding the funds for innovation or expansion. Finally, poor cash flow makes it difficult to hire and retain good employees.
It is important to distinguish between true cash management and a more general subject of liquidity management. The distinction is a source of confusion because the word cash is used in practice in two different ways. First, it has its literal meanings, actual cash on hand. However, financial managers frequently use the word to describe a firm’s holdings of cash along with its marketable securities, and marketable securities are sometimes called cash equivalents or near cash. Liquidity management concerns the optima quantity for liquid asset management policies. Cash management is much more closely related to optimizing mechanisms for collecting and disbursing cash, and it’s this subject that we primarily focus on this chapter.
Key Indicators in Cash Management
Without adequate cash flow, a firm can become technically insolvent even though assets far out way the liabilities. To reduce the chances for a firm becoming technically insolvent, the following parameters have been recommended to be employed in evaluating the effectiveness of a cash management system. These includes:
- Cash conversion cycle
- Operation cash flows
- Increase of decrease in cash
- Liquidity flow index
1. Cash Conversion Cycle
This is the time interval between actual cash payment/expenditure for the purchase of productive/operational resources and the ultimate collection of cash from the sales of products/services. The cash conversion cycle provides a valid alternative for measuring company liquidity. The longer the time taken to get back the money paid out, the more the likely hood the organization is to face technical insolvency and vice versa.
2. Operational Cash Flows
Cash flows from operations are the amount of cash a firm generates in a measured time from its operation. Various methods are used to determine the amount of operating cash flow. The prevalent methods use the income statement and the balance sheet to prepare the cash flow statement (also called statement of sources and application of funds).
Positive cash flows indicate how much cash the organization has generated from operations during the financial year. Negative cash flows indicate how much additional cash has been used to support the operations during the same period. Usually, a firm with negative cash flow from operations is unable to finance its operations. De facto, it is consuming cash flows rather than generating them. It becomes prone to technical insolvency problems and it may go bankruptcy.
Cash flow accounting involves the reporting of classified list of last year’s cash flows, and a set of forecast cash flows, with supporting analysis of the variances between last year’s actual and forecast cash flows. It therefore emphasizes the most fundamental events in business activities, cash flows into and out of the firm, and the segregation of past (cash) facts from future estimates, accounting time period allocation, based on estimates of consumption are avoided.
The result is a set of statements that is objective, understandable and simple, and which meets the needs of a variety of users concerned with stewardship, liquidity, performance appraisal and investment. In particular, cash flow accounting meets one of the fundamental accounting objectives, to provide information useful to investors and creditors for predicting, comparing and evaluating potential cash flows to them in terms of amount, timing and related uncertainty.
Cash flows provide data, which, because it is properly dated, can be discounted at a rate, selected by the user, and which does not required level adjustments, although comparisons over time require, and the data permit general price level adjustment to a base period.
Finally, the use of a cash flow statement integrates trading activities and investments, dividends and financing policies, unlike information presented in profit and loss account and balance sheet format.
However, critics of the cash flow system argue that cash flow reports can be distorted, for example, by delaying payments to creditors, and as they ignore non-cash changes in assets and liabilities, including holding gains and losses, so that no estimate is provided of the extent to which these flows were obtained by consumption of assets. Operating cash flows have also be found to be poor predictors of failure.
3. Increase or Decrease in Cash
A corporation’s cash flow statement shows whether the firm has increase or decrease its cash during the period for which the statement refers. Cautiously a decrease can be indicative of how unsatisfactory the firms operations have been during the year and vice versa. Since profits are not cash, a firm may realize profits but still be technically insolvent.
If cash flows are generated a firm may remain in business for several years while still making losses. Usually, with meticulously handled double entry account system, the decrease or increase in cash is simply the difference between opening cash balance and the closing balance.
4. Liquidity Flow Index (LFI)
The Liquidity Flow Index (LIF) indicates the relationship between the amount of cash that will be available for meeting the obligations and the amount of cash required to meet such obligation during the same period. It is cash budget’s ratio of operating cash influence to the required cash outflows for a particular period.
Maintaining liquidity may add value to a firm. A firm that faces variable demand can add value by maintaining liquidity to permit it operating flexibly since changes in operating levels can be more expensive than changes in liquidity or working capital.
Thus liquidity can enhance firm value by reducing the systematic components of its risk as it reduces the firm’s susceptibility to economic fluctuations. In addition, the value of a firm may be enhanced by its liquidity because of its ability to act as a financial intermediary for its customers and suppliers. A firm may be able to add value by doing this because of imperfections in financial markets. Further, under asymmetric information, a liquid firm may be able to fund valuable projects that may be difficult or costly to fund in financial markets.
In the case of firms operating in multinational settings, maintaining liquidity may additionally allow a firm opportunity for arbitrage between segmented national capital markets and institutional settings. Such firms also face additional opportunities and challenges in managing liquidity under currency and political risks. Thus, because of the wide spread segmentation of national financial markets, the ability to increase firm value by internalizing the rates due to the market imperfections through liquidity managements apply even to a great extent to firms operating in multinational settings.
To illustrate this difference between the domestics and the multinational settings, nations can be defined as regions whose residents have different purchasing power indexes. National group of investors, therefore delineated by deviations from purchasing power parity which causes them to use different price indexes and deflating the monetary returns from the same security. In practice, nations may further be separated by such manifestations of sovereignty as taxes, and exchange and border controls, which restrict access to local capital markets.