The Importance of Cash

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 a way to meet financial obligations.

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

In banking, liquidity is meeting 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). In contrast, 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 cannot 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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Defining the Cash Flow Cycle

The cash flow cycle is also called the "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 to expand customer sales. It is thus a measure of the liquidity risk entailed by growth. However, shortening the CCC creates its 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 is 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 a 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 the 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 on 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 and is written to accommodate such a firm. For a cash-only firm, the equation would only need data from sales operations (e.g., inventory changes) because disbursing cash would be directly measurable as purchasing inventory, and collecting cash would be directly measurable as selling 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

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

CCC = the number of 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 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 surrounding the period: (Lt1+Lt2)/2.

To estimate its RATE, we note that Accounts Receivable grow only when revenue is accrued; Inventory shrinks, and Accounts Payable grow 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 item 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 their inventory).

Aims of CCC

Our aim in studying the cash conversion cycle and its calculation is to change our policies regarding credit purchases and sales. Based on reports of the cash conversion cycle, we can change our standard of payment for credit purchases or get cash from our debtors. If it shows a good cash liquidity position, we can maintain our past credit policies. The study also aims to study a business's cash flow. A cash flow statement and cash conversion cycle study will be helpful for cash flow analysis.

Components of the 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 it will need outside financing.

A Sample Balance Sheet One of the assets listed is cash, a factor in 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, are 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 billing 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. They are the portion of corporate profits paid out to stockholders. When a corporation earns a profit or surplus, that money can be used for two purposes: it can either be re-invested in the business (called retained earnings) or 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 assets – equipment, machine, real estate, etc.
   
   
4. Payments related to mergers and acquisitions.
   
   
5. Interest paid – interest on 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 payments include advertising, selling, administration, insurance, rent, etc.

Net increase in cash and cash equivalents

Cash balance, end of year