The Importance of Cash and Cash Management

Reasons for Maintaining Cash on Hand

The main reason a business maintains cash on hand is to meet financial obligations.

In business, economics, or investment, market liquidity is an asset's ability to be sold without causing a significant movement in the price and with minimum loss of value. Money, or cash, is the most liquid asset, and can be used immediately to perform economic actions like buying, selling, paying debt, and meeting immediate wants and needs.

In bookkeeping and accounting, cash refers to current assets comprising currency or currency equivalents that can be accessed immediately or near immediately (as in the case of money market accounts). Cash is seen as a reserve for payments and as a way to meet financial obligations.

Cash: A business's cash account is how much currency it has on hand at a given time.

In banking, liquidity is the ability to meet obligations when they come due without incurring unacceptable losses. Managing liquidity is a daily process requiring bankers to monitor and project cash flows to ensure adequate liquidity is maintained. Maintaining a balance between short-term assets and short-term liabilities is critical. For an individual bank, clients' deposits are its primary liabilities (in the sense that the bank is meant to give back all client deposits on demand), whereas reserves and loans are its primary assets (in the sense that these loans are owed to the bank, not by the bank). The investment portfolio represents a smaller portion of assets, and serves as the primary source of liquidity. Investment securities can be liquidated to satisfy deposit withdrawals and increased loan demand. Banks have several additional options for generating liquidity, such as selling loans, borrowing from other banks, borrowing from a central bank, such as the U.S. Federal Reserve Bank, and raising additional capital. In a worst case scenario, depositors may demand their funds when the bank is unable to generate adequate cash without incurring substantial financial losses. In severe cases, this may result in a bank run. Most banks are subject to legally mandated requirements intended to help banks avoid a liquidity crisis.

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Source: Boundless, https://courses.lumenlearning.com/boundless-finance/chapter/the-importance-of-cash/
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Defining the Cash Flow Cycle

The cash flow cycle measures how long it takes for a firm to recover cash that it invests in ongoing operations.

Cash flow cycle also is called "cash conversion cycle" (CCC). In management accounting, the CCC measures how long a firm will be deprived of cash if it increases its investment in resources in order to expand customer sales. It is thus a measure of the liquidity risk entailed by growth. However, shortening the CCC creates its own risks: while a firm could even achieve a negative CCC by collecting from customers before paying suppliers, a policy of strict collections and lax payments is not always sustainable.

Cash Conversion Cycle

The cash conversion cycle refers to the time frame between a firm's cash disbursement and cash collection. However, the CCC cannot be directly observed in cash flows, because these are also influenced by investment and financing activities; it must be derived from statement of financial position or balance sheet data associated with the firm's operations.

Retail

Although the term "cash conversion cycle" technically applies to a firm in any industry, the equation is formulated to apply specifically to a retailer. Since a retailer's operations consist of buying and selling inventory, the equation models the time between the following:

1. Disbursing cash to satisfy the accounts payable created by purchase of inventory; and
2. Collecting cash to satisfy the accounts receivable generated by that sale.

The CCC must be calculated by tracing a change in cash through its effect upon receivables, inventory, payables, and finally back to cash, thus, the term cash conversion cycle, and the observation that these four accounts "articulate" with one another.

The equation describes a firm that buys and sells on account. Also, the equation is written to accommodate a firm that buys and sells on account. For a cash-only firm, the equation would only need data from sales operations (e.g., changes in inventory), because disbursing cash would be directly measurable as purchase of inventory, and collecting cash would be directly measurable as sale of inventory.

However, for a firm that buys and sells on account, Increases and decreases in inventory do not occasion cash flows but accounting vehicles (receivables and payables, respectively); increases and decreases in cash will remove these accounting vehicles (receivables and payables, respectively) from the books.

Calculating the Cash Flow Cycle

Cash flow cycle = # days between disbursing cash and collecting cash in connection with undertaking a discrete unit of operations.

Key Terms

• Credit Sales: Credit Sales are all sales made on credit.

Cash Flow Cycle

The cash flow cycle is also called cash conversion cycle (CCC).

CCC=# days between disbursing cash and collecting cash in connection with undertaking a discrete unit of operations.

= Inventory conversion period + Receivables conversion period – Payables conversion period

Inventory conversion period = Avg. Inventory / (COGS / 365)

Receivables conversion period = Avg. Accounts Receivable / (Credit Sales / 365)

Payables conversion period = Avg. Accounts Payable / (Purchases / 365)

There are five important intervals, referred to as conversion cycles (or conversion periods):

• The Cash Conversion Cycle emerges as interval C→D (i.e., disbursing cash→collecting cash).
• The payables conversion period (or "Days payables outstanding") emerges as interval A→C (i.e., owing cash→disbursing cash)
• The operating cycle emerges as interval A→D (i.e., owing cash→collecting cash)
• The inventory conversion period or "Days inventory outstanding" emerges as interval A→B (i.e., owing cash→being owed cash)
• The receivables conversion period (or "Days sales outstanding") emerges as interval B→D (i.e., being owed cash→collecting cash)

Knowledge of any three of these conversion cycles permits derivation of the fourth (leaving aside the operating cycle, which is just the sum of the inventory conversion period and the receivables conversion period.)

Hence, interval {C → D}=interval {A → B}+interval {B → D}–interval {A → C}

In calculating each of these three constituent conversion cycles, we use the equation TIME =LEVEL/RATE (since each interval roughly equals the TIME needed for its LEVEL to be achieved at its corresponding RATE).

We estimate its LEVEL "during the period in question" as the average of its levels in the two balance sheets that surround the period: (Lt1+Lt2)/2.

To estimate its RATE, we note that Accounts Receivable grows only when revenue is accrued; and Inventory shrinks and Accounts Payable grows by an amount equal to the COGS expense (in the long run, since COGS actually accrues sometime after the inventory delivery, when the customers acquire it).

• Inventory conversion period: Rate = COGS, since this is the item that (eventually) shrinks inventory.
• Receivables conversion period: Rate = revenue, since this is the item that can grow receivables (sales).
• Payables conversion period: Rate = [inventory increase + COGS], since these are the items for the period that can increase "trade accounts payables" (i.e., the ones that grew its inventory).

Aims of CCC

Our aim of studying cash conversion cycle and its calculation is to change the policies relating to credit purchase and credit sales. We can change our standard of payment of credit purchase or getting cash from our debtors on the basis of reports of cash conversion cycle. If it tells good cash liquidity position, we can maintain our past credit policies. Its aim is also to study cash flow of business. Cash flow statement and cash conversion cycle study will be helpful for cash flow analysis.

Components of the Cash Budget

The cash budget includes the beginning balance, detail on payments and receipts, and an ending balance.

Key Terms

• stockholders: A shareholder or stockholder is an individual or institution (including a corporation) that legally owns a share of stock in a public or private corporation.
• mergers and acquisitions: Mergers and acquisitions (abbreviated M&A) is an aspect of corporate strategy, corporate finance, and management dealing with the buying, selling, dividing and combining of different companies and similar entities that can help an enterprise grow rapidly, whether in its sector or location of origin, or a new field or new location, without creating a subsidiary, other child entity, or using a joint venture.

Cash Budget

A cash budget is a prediction of future cash receipts and expenditures for a particular time period, usually in the near future. The cash flow budget helps the business determine when its income will be sufficient to cover its expenses and when the company will need to seek outside financing.

A Sample Balance Sheet: One of the assets listed is cash, which factors into the overall budget.

Components: Major classes include cash receipts and payments.

Cash Balance, Beginning of the Year

Cash Receipts

1. Cash generated from operations
2. Cash receipts from customers - Collecting the accounts receivable. Accounts receivable, also known as Debtors, is money owed to a business by its clients (customers) and shown on the business's balance sheet as an asset. It is one of a series of accounting transactions dealing with the billing of a customer for goods and services that the customer has ordered.
3. Proceeds from the sale of equipment
4. Dividends received: Dividends are payments made by a corporation to its shareholder members. It is the portion of corporate profits paid out to stockholders. When a corporation earns a profit or surplus, that money can be put to two uses: it can either be re-invested in the business (called retained earnings), or it can be distributed to shareholders.
5. Other income: Other investment or other interest income, etc.

Cash Payments

1. Cash paid to suppliers
2. Cash paid to employees - Salary, wages expenses.
3. Purchase of asset - Equipment, machine, real estate, etc.
4. Payments related to mergers and acquisitions
5. Interest paid - Interest of short-term or long-term debt.
6. Income taxes paid
7. Dividends paid - Paying dividends to shareholders or investors.
8. Debt paid - Short term or long term debt principle.
9. Other payment - Which includes Advertising, Selling expenses, Administrative expense, Insurance expenses, Rent expenses, etc.

Net increase in cash and cash equivalents

Cash balance, end of year

Managing Float

Float is the term used to represent duplicate money present between the time a deposit is made and when the deposit clears the bank.

Key Terms

• check kiting: a form of check fraud, involving taking advantage of the float to make use of non-existent funds in a checking or other bank account.

Managing Float

The term float is used in finance and economics to represent duplicate money present in the banking system during the time between when a deposit is made in the recipient's account and when the money is deducted from the sender's account. Float is also associated with the amount of currency available to trade - i.e., countries can manipulate the worth of their currency by restricting or expanding the amount of float available to trade. Float is most apparent in the time delay between a check being written and the funds to cover that check being deducted from the payer's account. Once the recipient, or payee, deposits the check in the corresponding account, the bank immediately credits (increases) the payee's account, assuming that the payer's bank will ultimately send the funds to cover the check. Until the payer's bank actually sends the funds, both the payer and the payee have the same money in their accounts. Once the payee's bank notifies the payer's bank of a pending check, the duplicate funds will be removed from the payer's account and the checks will be considered to have cleared the bank. In check clearing, bank float and customer float are present.

Bank float is the time it takes to clear the funds, from the time they were deposited to the time they were credited to the depositing bank. Customer float is defined as the span of time between the deposit to the time the funds are released for use by the depositor. The difference between the bank float and the customer float is called negative float. Negative float is used by the bank as the overnight investable funds. Float can cause marginal changes in the money supply. Before electronic check clearing, bad weather or communication problems often caused float to significantly increase, as the clearing of checks was delayed. Another aspect of float time is its use to defraud, commonly known as check kiting.

Float In Relation To Cash Management

When managing cash disbursements, a company should endeavor to increase the amount of time present in the disbursement cycle. In other words, it is appropriate to delay making payments until they come due in order to have use of available cash for as long as possible. Some methods for accomplishing this include mailing checks far away from those waiting to receive payment, disbursing checks from a remote bank, or purchasing with credit cards. Methods such as these present a company with three types of float to take advantage of:

1. Mail Float: Time spent in the mail.
2. Clearance Float: Time spent trying to clear the bank.
3. Processing Float: Time required to process cash flow transactions.

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Source: Boundless, https://rachel.worldpossible.org/mods/en-boundless/www.boundless.com/finance/textbooks/boundless-finance-textbook/working-capital-management-18/cash-management-126/index.html
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Managing Collections

A company must balance its need for quick cash collections with the needs and desires of its customers.

Key Terms

• invoicing: the production of a commercial document issued by a seller to the buyer, indicating the products, quantities, and agreed prices for products or services the seller has provided the buyer.
• lockbox: a service offered to organizations by commercial banks that simplifies collection and processing of account receivables by having those organizations’ customers' payments mailed directly to a location accessible by the bank

Managing Cash Collections

The cash receipts cycle requires a diligent collection process. A company must balance this need for quick cash collections with the needs and desires of its customers. For example, customers who are important to a firm's business should be treated carefully as opposed to customers who mean little or nothing to its future. Therefore, collection efforts must be customer specific in order to be effective. Specific collection techniques include letters, telephone calls, faxes, emails, and legal action. An example of a collection letter follows:

The overall collection process should be pro-active and preventive. For example, wherever possible a company should try to collect payment immediately as products or services are delivered, i.e., receive payment in cash. This eliminates the need for invoicing and follow up collection techniques. A firm should always require deposits from customers that have a history of making late payments. It should use credit applications to weed out bad customers, and include a clause in the credit application that states all collection costs are reimbursed by the customer on delinquent accounts.

 Example Collection Letter  A sample collection settlement letter.

Lock Box Banking

Lock box banking is a service offered to companies by commercial banks that simplifies collection and processing of account receivables. In general, a lockbox is a Post Office box that is accessible by a bank. A company may set up a lock box service with their bank for receiving customers' payments. The company's customers send their payments to the PO box, and the bank subsequently collects and processes these payments directly and deposits them to the company's account. Because the bank is making the collection, the funds that have been received are immediately deposited into the company's account without first being processed by the company's accounting system, thereby speeding up cash collection. Another benefit of the lockbox service is that a company can maintain special mailboxes in different locations around the country. A customer then sends payment to the closest lockbox.

Managing Disbursements

How a company manages various disbursements and current assets can have a significant impact on its cash flows.

Key Terms

• outsourcing: The transfer of a business function to an external service provider.

Managing Cash Disbursements

Cash Disbursements Cash payments are vitally important to manage in order to maintain a successful business.

How a company manages various disbursements and current assets can have a significant impact on its cash flows. There are several problem areas to watch out for, such as payroll, purchasing, inventories, and insurance.

Payroll

Payroll is a hefty cash outflow and requires special attention. One obvious trend in payroll management is to implement a flexible work force, since the flow of work fluctuates. Outsourcing and temporary workers are often part of a flexible workforce. However, a company must retain a full-time workforce for core activities. A firm can also increase payroll float times by simply distributing payroll checks after the point when banks will clear checks.

Purchasing

Flexible purchasing practices can help a company maintain and generate cash flow. A company may consider renting certain items as opposed to purchasing. A manager may ask, do we really need this item, and how often will we use it? If practical, a firm can order items out of season when prices are low. Finally, a firm may consider using credit cards to make purchases since this will allow more time for making payment.

Inventory

Inventories have several hidden costs that can drain cash flow. These costs include storage, insurance, spoilage, handling, taxes, and financing. A company should get rid of inventory that is not moving. Obsolete inventory should be removed immediately. A firm may also find new ways of disposing of inventory. For example, it is better to sell inventory at costs than not at all. The overall objective is to maintain inventory levels at a profitable level.

Insurance

A company should make sure it does not over insure the business. A firm should purchase insurance in group packages to obtain the lowest premiums. It should start by covering the largest risks first. It should then structure as high a deductible as is affordable. A company should avoid duplication and excessive insurance and shift certain costs, such as health insurance, to the employee through higher payroll deductions. Insurance should be used to cover risks that are material but occur infrequently.