Cash and finances are the living cells in businesses. A living thing becomes dead immediately the living tissues stop working. This is applicable to our businesses. Without proper cash management, the entire business model will ultimately come to a grind. This is why managers of all forward thinking businesses should have answer to the question: what is cash management? Having good cash management skill is an important attribute of a manager as this will go a long way in ensuring that a business does not overtrade. A growing firm with excellence performance will not survive if it runs out of cash.
The purpose of this article is to explain what cash management means in a modern business environment and to give tips on how to manage cash in an efficient manner.
DEFINITION | EXPLANATION AND MEANING OF CASH MANAGEMENT
Cash management is an aspect of working capital management which deals managing monies of an entity in order to maximise cash availability as well as obtaining the maximum interest from idle cash. Cash cycle is a term used to describe all that happened between when an organization makes payment for its purchases or services received and the period when receivables are collected. Notice that cash management is not the same thing as working capital management.
REASONS FOR HOLDING CASH
There are practically two main reasons why modern businesses hold money in the form of cash. The first is to meet transactional requirements. The transactional motive of holding money comes from periodic disbursement and collection activities of a going concern. The disbarment of cash may include things like payment of: wages and salaries, taxes, dividends, rent, business related debt, etc. On the other hand, cash is collected from: normal business operations, sale of company asset, and other sources of finance. It all boils down to collecting cash as quick as possible and paying cash as slow as possible. A company that does not understand this simple yet, powerful cash flow trick will always struggle to remain liquid.
Another reason for holding cash is to meet minimum requirement balances. Banks require that you keep certain balance with them to compensate for the free financial services that they render to you. It is a costly mistake for a company to see the transaction cash and compensatory balances when attempting to get the cash flow outlook of the firm as different. The cash can be used to conveniently satisfy both cash requirements.
Basic economics tells us that the cost of holding cash include the opportunity cost of lost income in the form of interest. Similarly, the cost of running out of cash can mark an end to the existence of a company. This is why it is important to determine the optimal cash level or target cash that a company needs to keep at all given time. To get the target cash, a company must weigh the cost of holding cash against the benefits of holding cash.
ESTIMATING TARGET CASH BALANCE
Target cash balance or optimum cash level is all about trading-off between what the economist call opportunity costs of holding too much cash and trading implication of holding too little. There are basically two main methods of estimating target cash. These are: the Baumol Model and the Miller-Orr Model. William Baumol was the first to develop a cash management formula that takes both opportunity cost and trading cost into consideration. After a few observations were made by finance scholars regarding the inability of the Baumol model to account for the random movements in cash flows, Merton Miller and Daniel Orr developed a cash management model which dealt with the cash-flow flaw. You can do a search on these topics for detailed work on them.
WHAT IS FLOAT IN CASH MANAGEMENT?
There is always a difference between the amount of cash shown on a company’s statement of financial position (balance sheet) and that shown on the bank statement of the company. The difference between cash in bank and that on the books of account is called float (notice the contextual difference in usage of the term float here and imprest accounting system/petty cashbook). The primary cause for this (float) net difference is the presence of cheque in collection process.
There are complex financial engineering processes surrounding the use of float to manage cash. The simplest form however is described in the example below:
SIMPLE EXAMPLE OF USING FLOAT TO MANAGE CASH
Suppose that Accountant Next Door (AND) Plc currently has £200,000 on deposit with its bank. It purchases some equipment for its consulting head office for £200,000 paying by a post dated cheque (approximately one month). That £200,000 will be deducted from the cash book of AND but will still remain in its bank until the check is presented and processed. AND can decide to invest this money in a marketable short term security that matures in 29 days and make extra cash from it.
CASH COLLECTION AND CASH DISBURSEMENT STRATEGIES
The various collection and disbursement strategies that a company can use to improve its cash management is a two way game. The first phase of the game involves acceleration of collections which has to do with reducing the delay between when a customer pays us by cheque and when the money drops in our bank account. A number of techniques are used to reduce this cycle and they include; (a) encouraging our customers to speed up the cheque mailing method- we can offer to bear the extra cost of using an overnight delivery for instance, (b) reducing the time it takes to bank cheques received from our customers, and (c) speeding up the movement of funds to disbursement bank.
It is important to state that the simple act of encouraging your customers to set up a direct debit with you is a more efficient way of managing cash by completely avoiding the use of cheques. The only drawback here is that one condition must be met for a direct debit to be used: – the customer must be a regular customer that buys periodically.
THREE STRATEGIES THAT HELP ACCELERATE CASH COLLECTION
- Use of wire transfer
- Use of lockboxes
- Adopting concentration banking
THREE STRATEGIES FOR DELAYING DISBURSEMENT
- Draw a cheque in a bank that is far from the customer
- Hold payment for some days after postmarked in office
- Add a layer of bureaucracy to the process by calling your customer to verify large sums
In as much as it is tempting to employ the above techniques of delaying cash disbursement, there are however some business ethics and legal issues that the financial manager of a company must have to consider before making decision on whether to use them or not.
Whatever you are doing as a financial manager attempting to get the best cash management mix for your organization, do not forget the fact that technology has improved so much that leveraging on some bye product of technology will make the whole process of cash management seem easy and simple.