Cash Management (Encyclopedia of Small Business)
Cash management is a broad term that refers to the collection, concentration, and disbursement of cash. It encompasses a company's level of liquidity, its management of cash balance, and its short-term investment strategies. In some ways, managing cash flow is the most important job of business managers. If at any time a company fails to pay an obligation when it is due because of the lack of cash, the company is insolvent. Insolvency is the primary reason firms go bankrupt. Obviously, the prospect of such a dire consequence should compel companies to manage their cash with care. Moreover, efficient cash management means more than just preventing bankruptcy. It improves the profitability and reduces the risk to which the firm is exposed.
Cash management is particularly important for new and growing businesses. As Jeffrey P. Davidson and Charles W. Dean indicated in their book Cash Traps, cash flow can be a problem even when a small business has numerous clients, offers a superior product to its customers, and enjoys a sterling reputation in its industry. 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 only natural that major business expenses are incurred in the production of goods or the provision of services. In most cases, a business incurs such expenses before the corresponding payment is received from customers. In addition, employee salaries and other expenses drain considerable funds from most businesses. These factors make effective cash management an essential part of any business's financial planning. "Cash is the lifeblood of a [store]," wrote Richard Outcalt and Patricia Johnson in Playthings. "Without cash for inventory, payroll, and other expenses, an emergency is imminent."
When cash is received in exchange for products or services rendered, many small business owners, intent on growing their company and tamping down debt, spend most or all of these funds. But while such priorities are laudable, they should leave room for businesses to absorb lean financial times down the line. The key to successful cash management, therefore, lies in tabulating realistic projections, monitoring collections and disbursements, establishing effective billing and collection measures, and adhering to budgetary restrictions.
CASH COLLECTION AND DISBURSEMENT
Cash collection systems aim to reduce the time it takes to collect the cash that is owed to a firm. Some of the sources of time delays are mail float, processing float, and bank float. Obviously, an envelope mailed by a customer containing payment to a supplier firm does not arrive at its destination instantly. Likewise, the payment is not processed and deposited into a bank account the moment it is received by the supplier firm. And finally, when the payment is deposited in the bank account oftentimes the bank does not give immediate availability to the funds. These three "floats" are time delays that add up quickly, and they can force struggling or new firms to find other sources of cash to pay their bills.
Cash management attempts, among other things, to decrease the length and impact of these "float" periods. A collection receipt point closer to the customererhaps with an outside third-party vendor to receive, process, and deposit the payment (check)s one way to speed up the collection. The effectiveness of this method depends on the location of the customer; the size and schedule of their payments; the firm's method of collecting payment; the costs of processing payments; the time delays involved for mail, processing, and banking; and the prevailing interest rate that can be earned on excess funds. The most important element in ensuring good cash flow from customers, however, is establishing strong billing and collection practices.
Once the money has been collected, most firms then proceed to concentrate the cash into one center. The rationale for such a move is to have complete control of the cash and to provide greater investment opportunities with larger sums of money available as surplus. There are numerous mechanisms that can be employed to concentrate the cash, such as wire transfers, automated clearinghouse (ACH) transfers, and checks. The tradeoff is between cost and time.
Another aspect of cash management is knowing a company's optimal cash balance. There are a number of methods that try to determine this magical cash balance, which is the precise amount needed to minimize costs yet provide adequate liquidity to ensure bills are paid on time (hopefully with something left over for emergency purposes). One of the first steps in managing the cash balance is measuring liquidity, or the amount of money on hand to meet current obligations. There are numerous ways to measure this, including: the Cash to Total Assets ratio, the Current ratio (current assets divided by current liabilities), the Quick ratio (current assets less inventory, divided by current liabilities), and the Net Liquid Balance (cash plus marketable securities less short-term notes payable, divided by total assets). The higher the number generated by the liquidity measure, the greater the liquiditynd vice versa. However, there is a tradeoff between liquidity and profitability which discourages firms from having excessive liquidity.
CASH MANAGEMENT IN TROUBLED TIMES
Many small business experience cash flow difficulties, especially during their first years of operation. But entrepreneurs and managers can take steps to minimize the impact of such problems and help maintain the continued viability of the business. Suggested steps to address temporary cash flow problems include:
- Create a realistic cash flow budget that charts finances for both the short term (30-60 days) and longer term (1-2 years).
- Redouble efforts to collect on outstanding payments owed to the company. "Bill promptly and accurately," counseled the Journal of Accountancy. "The faster you mail an invoice, the faster you will be paid.f deliveries do not automatically trigger an invoice, establish a set billing schedule, preferably weekly." Businesses should also include a payment due date.
- Offer small discounts for prompt payment.
- Consider compromising on some billing disputes with clients. Small business owners are understandably reluctant to consider this step, but in certain cases, obtaining some cashven if your company is not at fault in the disputeor products sold/services rendered may be required to pay basic expenses.
- Closely monitor and prioritize all cash disbursements.
- Contact creditors (vendors, lenders, landlords) and attempt to negotiate mutually satisfactory arrangements that will enable the business to weather its cash shortage (provided it is a temporary one). In some cases, you may be able to arrange better payment terms from suppliers or banks. "Better credit terms translate into borrowing money interest-free," states the Journal of Accountancy.
- Liquidate superfluous inventory.
- Assess other areas where operational expenses may be cut without permanently disabling the business, such as payroll or goods/services with small profit margins. "Every operation struggling for survival is losing money in some of its components," observed Outcalt and Johnson. "[As you analyzed your business], you probably noticed some places where cash was bleeding out of your business without an adequate return. Plan to step the bleeding; that isut out the losers."
Cardarella, Toni. "Small Businesses Must Put Effort into Getting Customers to Pay on Time." Knight-Ridder/Tribune Business News, September 21, 1997.
Davidson, Jeffrey P., and Charles W. Dean. Cash Traps: Small Business Secrets for Reducing Costs and Improving Cash Flow. New York: Wiley, 1992.
Hertenstein, Julie H., and Sharon M. McKinnon. "Solving the Puzzle of the Cash Flow Statement." Business Horizons. January-February 1997.
Hill, Ned C. and William L. Sartoris. Short-Term Financial Management. New York: Macmillan, 1992.
Outcalt, Richard F., and Patricia Johnson. "Coping with a Cash Crunch." Playthings. March 1997.
Preston, Candace L. "Early Action Avoids Slow Cash Flow." Business First-Columbus. September 26, 1997.
Shulman, Joel S. and Raymond A.K. Cox. "An Integrative Approach to Working Capital Management." Journal of Cash Management. November/December 1985.
"Ten Ways to Improve Small Business Cash Flow." Journal of Accountancy. March 2000.
Cash Management (Encyclopedia of Business)
Cash management is a broad area having to do with the collection, concentration, and disbursement of cash including measuring the level of liquidity, managing the cash balance, and short-term investments.
If at any time, because of a lack of cash, a corporation fails to pay an obligation when it is due, the corporation is insolvent. Insolvency is the primary reason firms go bankrupt. Obviously, the prospect of such dire consequence compels companies to manage their cash with care. Moreover, efficient cash management means more than just preventing bankruptcy. It improves the profitability and reduces the risk the firm is exposed to.
COLLECTION AND DISBURSEMENT
Cash collection systems aim to reduce the time it takes to collect the cash that is owed to the firm (for example, from its customers). The time delays are categorized as mail float, processing float, and bank float. Obviously, an envelope mailed by a customer containing payment to a supplier firm does not arrive at its destination instantly. Likewise, the moment the firm receives payment it is not deposited in its bank account. And finally, when the payment is deposited in the bank account oftentimes the bank does not give immediate availability to the funds. These three "floats" are time delays that add up quickly, requiring the firm in the meantime to find cash elsewhere to pay its bills. Cash management attempts to decrease the time delays in collection at the lowest cost. A collection receipt point closer to the customer, such as a lock box, with an outside third-party vendor to receive, process, and deposit the payment (check) will speed up the collection. For example, if a firm collects $10 million each day and can permanently speed up collections by five days, at 6 percent interest rates, then annual before-tax profits would increase by $3 million. The techniques to analyze this case would utilize data involving where the customers were; how much and how often they pay; the bank they remit checks from; the collection sites the firm has (their own or a third-party vendor); the costs of processing payments; the time delays involved for mail, processing, and banking; and the prevailing interest rate that can be earned on excess funds.
Once the money has been collected, most firms then proceed to concentrate the cash into one center. The rationale for such a move is to have complete control of the cash and to provide greater investment opportunities with larger sums of money available as surplus. There are numerous mechanisms that can be employed to concentrate the cash, such as wire transfers, automated clearinghouse transfers, and checks. The tradeoff is between cost and time.
Disbursement is the opposite of collection. Here, the firm strives to slow down payments. It wants to increase mail delays and bank delays, and it has no control over processing delay.
OPTIMAL CASH BALANCE
Another aspect of cash management is knowing the optimal cash balance. There are a number of methods that try to determine the magical cash balance, which should be targeted so that costs are minimized and yet adequate liquidity exists to ensure bills are paid on time (hopefully with something left over for emergency purposes). One of the first steps in managing the cash balance is measuring liquidity. There are numerous ways to measure this, including: cash to total assets ratio, current ratio (current assets divided by current liabilities), quick ratio (current assets less inventory, divided by current liabilities), and the net liquid balance (cash plus marketable securities less short-term notes payable, divided by total assets). The higher the number generated by the liquidity measure, the greater the liquidity and vice versa. There is a trade off, however, between liquidity and profitability that discourages firms from having excessive liquidity.
CASH MANAGEMENT MODELS
To help manage cash on a day-to-day basis in actual dollars and cents, there are a number of cash management models. These include the Baumol Model, Miller-Orr Model, and the Stone Model.
The Baumol Model is similar to the Economic Order Quantity (EOQ) Model. Mathematically it is:
where C = the optimal amount of cash to be acquired when reaching a threshold balance,
F = the fixed cost of acquiring the cash C amount,
S = the amount of cash spent during a time interval,
i = the interest rate expressed in the same time interval as S
One shortcoming of this model is that it accommodates only a net cash outflow situation as opposed to both inflows and outflows. Also, the cash outflow is at a constant rate, with no variation.
The Miller-Orr Model rectifies some of the deficiencies of the Baumol Model by accommodating a fluctuating cash flow stream that can be either inflow or outflow. The Miller-Orr Model has an upper limit U and lower limit L
When there is too much cash and U is reached, cash is taken out (to buy short-term securities to earn interest) such that the cash balance goes to a return (R) point. Otherwise, if there is too little cash and L is reached, cash is deposited (from the short-term investments) to replenish the balance to R. The equations of the Miller-Orr Model are:
where R = the return point,
f = the fixed cost for each transaction to withdraw or deposit cash,
s2 = the variance of the cash flows,
i = the interest rate per same time period as s2,
U = the upper limit
L is determined by other means, for example, compensating balance requirement, minimum balance to avoid bank service charges on checking account, or zero.
The Stone Model is somewhat similar to the Miller-Orr Model insofar as it uses control limits. It incorporates, however, a look-ahead forecast of cash flows when an upper or lower limit is hit to take into account the possibility that the surplus or deficit of cash may naturally correct itself. If the upper control limit is reached, but is to be followed by cash outflow days that would bring the cash balance down to an acceptable level, then nothing is done. If instead the surplus cash would substantially remain that way, then cash is withdrawn to get the cash balance to a predetermined return point. Of course, if cash were in short supply and the lower control limit was reached, the opposite would apply. In this way the Stone Model takes into consideration the cash flow forecast.
The goals of these models are to ensure adequate amounts of cash on hand for bill payments, to minimize transaction costs in acquiring cash when deficiencies exist, and to dispose of cash when a surplus arises. These models assume some cash flow pattern as a given, leaving the task of cash collection, concentration, and disbursement to other methods.
SHORT-TERM INVESTMENT DECISIONS
A key cash management problem (including how much money and for how long) concerns in which money market instruments should the temporary excess funds be placed. This short-term investment decision necessitates the analysis of return (need to annualize returns in order to compare) and liquidity. Only short-term investments meet the liquidity test, as long-duration instruments expose the investor to too much interest rate risk. In addition, federal government obligations are popular due to the absence of default risk and ease of resale in the secondary market. Nonetheless, there are numerous money market securities available with varying characteristics from many types of issuers.
Cash management is evolving with the increasing acceptance and use of electronic payments, such as debit cards. Shifting from paper-based payments to electronic transfers reduces the uncertainty in cash flow forecasting. The change in form of payment decreases both float and per item transaction costs. Stumbling blocks to the complete switchover to electronic payments include the initial equipment investment for businesses and resistance by consumers who still prefer checks. Nevertheless, the use of electronic versus paper payments is gaining, affecting the importance of current cash management techniques.
[Raymond A. K. Cox]
Maness, Terry S., and John T. Zietlow. Short-Term Financial Management Fort Worth: Dryden Press, 1998.
Phillips, Aaron L. "Migration of Corporate Payments from Check to Electronic Format: A Report on the Current Status of Payments." Financial Management 27, no. 4 (winter 1998): 92-105.
Shulman, Joel S., and Raymond A. K. Cox. "An Integrative Approach to Working Capital Management." Journal of Cash Management 5 (November/December 1985): 64-67.