Cash is the most important aspect of operating a business. It is the basic input that keeps business running on a day to day basis. Therefore, it is necessary to manage cash effectively as a business’ operating environment is quite volatile.
Therefore, a firm with a sufficient amount of cash is highly liquid. It has the ability to meet all of its expenses. Whereas, an illiquid firm does not have enough cash. The insufficiency of cash can act as a drag on the business operations.
Furthermore, your business needs to maintains an optimal amount of cash balance. This is because inadequate cash can slow down production. Whereas excessive cash can turn out to be expensive as it hampers the earning potential of your business. Further, idle cash carries an implied cost for your business. This cost is called the opportunity cost. The opportunity cost is in the form of losing out on the interest income. Thus, you could have earned this interest income by either investing idle cash in interest bearing securities or by paying off loans.
This means that having inadequate or surplus cash indicates mismanagement of that your business funds. Therefore, you must lay emphasis on maintaining an optimum balance of cash. And such a cash balance needs to be maintained at the right place, at the right time and at the right cost.
So let’s understand the meaning of cash management before discussing how effective cash management can improve your business outcomes.
What is Cash Management?
Cash management involves:
- reducing excessive amount of cash in hand
- utilizing cash effectively
- maintaining optimum balance of cash to meet planned and unexpected expenditures
- managing cash flows – that is cash disbursements and receipts at all times
Thus, cash management helps to manage your business’ working capital efficiently. This means that effective cash management indicates that your business’ working capital is managed efficiently. Thus, your business must have sufficient amount of cash at all times to meet its business needs.
So let’s understand the functions of cash management in order to develop strategies to manage cash effectively.
Functions of Cash Management
Your business needs to get rid of the unpredictability associated with cash flows and excess time gap between cash receipts and cash payments.Thus, you can develop strategies that help in managing cash effectively.
But efficient cash management requires cash planning, cash flow management, cash control and maintenance of adequate cash balance. Therefore, you need to develop strategies on the basis of such cash management functions.
I. Cash Planning
A business needs cash for meeting its short and long term business needs. These include financing current assets, fixed assets or making payments for operating expenses.
Now, assets and liabilities are either current or non-current. And these classifications have a big impact on cash management.
A current asset represents cash, or an asset that gets converted into cash within 12 months. For instance, accounts receivable and inventory are current assets. On the other hand, fixed assets such as machinery and equipment are non-current assets that will be used for years.
The most pressing cash management need for a business owner is to collect current assets in cash. This is because such cash is used to pay off the current liabilities. Therefore, planning your long-term cash needs is important. But you need to address any short-term cash problems now in order to keep your doors open.
So, there are times when a business generates sufficient profits but faces cash shortages on day to day basis. This is because earning profits does not translate to having sufficient cash for running the business. However, there are also times when the business has idle cash which impacts the earning potential of your business.
Thus, cash planning is essential. It helps business in determining future cash flows thereby reducing the chances of excess cash and cash deficit.
Hence, to undertake cash planning, business must prepare a cash budget.
What is a Cash Budget?
Cash budget is a statement that summarizes expected cash inflows and outflows of a business over a projected period of time. This statement provides information about the timing and amount of expected cash flow over the projected time period. It also helps a business to figure out its future cash needs and hence plan those needs accordingly. Furthermore, a cash budget helps a business in exercising control over its cash and liquidity position.
II. Managing Cash Flows
A business undertakes cash management to manage its :
- cash inflows and
- cash outflows
So, business must speed up its cash collections and delay cash payments as per the general principle. Thus, a business needs to maintain less cash if it increases the speed of receiving cash. However, these cash collections can be done in a lesser time. Thus, a business can reduce the time gap between customer payment and receipt of funds to speed up cash collections.
Now, cash collections (inflows) and cash disbursements (outflows) comprise of three components:
- Accounts Receivables
- Accounts Payables
- Difference between accounts receivables and payables
This balance represents the rupee amount of credit sales not collected in cash. In short, it is the money you own. Though, adding new customers may cause accounts receivable to increase quickly. But this can lead to cash shortage.
Assume you generate Rs. 10 lakhs in credit sales and the average customer pays in 30 days. Then, you increase credit sales to Rs. 12 lakhs in 2019. But the average customer now pays in 45 days.
In most cases accounts receivable increases. This is because the new customers pay more slowly on average. While your business generates Rs. 1 lakh in credit sales per month in 2019, it took 15 more days, on average, for customers to pay.
The growing accounts receivable balance means that cash inflows are slower. This means you may not be able to generate sufficient cash to operate each month. Increasing credit sales also means higher costs, and you need cash to pay for the higher costs.
You May Also Read
Small Business Tip: Manage Accounts Receivable To Boost Cash Flow
Business owners also need cash to make payroll, pay vendors, and possibly for debt payments.
Your accounts payable balance represents bills you must pay within 12 months and that balance is a current liability. Thus, you need to access a line of credit or raise more capital through a stock or bond offering if cash inflows are insufficient.
Hence, a business needs to manage cash effectively to avoid excess cash or cash deficits.
III. Determining Optimal Cash Balance
It is important for a business to have an ideal cash balance in order to meet its day to day obligations. Also, it needs cash that is sufficient enough to provide a cushion to business in unforeseen times.
So, a business needs to consider following factors to determine the optimal cash balance:
- risk associated with maintaining a given cash balance
- returns expected as an outcome of maintaining such a cash balance
Thus, a business suffers from cash shortage if it maintains a small amount of cash balance. As a result, the business would not be able to meet its expenses. Hence, it will either sell its marketable securities or borrow money to fill the gap.
Such a step would involve transaction cost. On the contrary, a business will have liquidity if it maintains high level of cash balance. But, it may lose out on the opportunity to earn interest income on excess cash. This loss is an opportunity cost for the firm.
Therefore, a business needs to maintain an optimum level of cash balance to get rid of cash deficits and excess cash situations.
So, the optimum cash balance is where the:
transaction costs + the risk of maintaining small amount of cash balance = the opportunity cost associated with having idle cash balance
IV. Investing Idle Cash
Idle cash must be invested properly. Therefore, a business should determine the proportion of cash balances to be invested in marketable securities and kept as bank deposits. Excess cash should normally be invested in marketable securities as such securities can be easily converted into cash. Excess cash, that is, cash left after meeting working capital needs of a business, may vary owing to business cycle and its seasonality.
Although a business might want to keep liquid cash to meet its future uncertainties. This is known as precautionary cash balance. But it may not be able to anticipate the exact amount needed to meet such exigencies. Hence, it is always better to invest excess cash in marketable securities as they are highly liquid.
Besides investing idle cash in marketable securities, a firm can also undertake short term credit as and when the need arises. Now, the decision of investing marketable securities or availing short term loan depends upon the firm’s policy with regard to financing mix of short term and long term.
Cash Flow Management Strategies
1. Collection Policy
Enforce a formal collection policy to manage your accounts receivable balance.
Your accounting software should provide an aging schedule for accounts receivable. The software groups your receivables based on when each invoice was issued. You should monitor this report and implement a collections process to email and possibly call clients to ask for payment.
2. Offer Discounts
Offer customers a discount, if they pay an invoice within 10 days. Sure, you’ll collect slightly less cash. But some customers will pay faster, which improves your cash inflows.
Now, suppose you offer customers a 5% discount if they pay within 10 days of receiving the invoice. In this case you may lose 5% of the revenue generated. But collecting cash sooner may eliminate the need to borrow money and pay interest costs.
3. Manage Inventory Effectively
Managing inventory is a balancing act.
Thus, you may keep a supply of finished items on hand as inventory if your business is manufacturing . Carrying an inventory balance allows you to quickly fill orders so that clients don’t have to wait.
But you want to minimize the dollars tied up in inventory, while making sure not to lose a potential sale.
Smart inventory management requires time and effort. You will need to analyze:
- the dollar amount of inventory carried in past years,
- sales generated, and
- the number of sales lost due to a stockout (when an inventory item is out of stock).
This analysis can help estimate the dollar amount of inventory needed.
Another tip for inventory management; develop a strong relationship with your largest customers. Understanding the future needs of your biggest clients allows you to pre-plan your own inventory needs.
4. Better Systems
Every business should use technology to collect cash faster. This includes using software tools that speed up the time it takes to transfer payments into the company bank account. Thus, you can dramatically improve your cash position if you can speed up cash inflows by just a few days.
Worth the Effort
Improving your cash management system requires time and effort. But your work will pay off. Use these tips to forecast your cash needs, speed up cash collections, and avoid borrowing money to operate your business.