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Four Steps to Proper Cash Management



The goal of business is to make a profit. Generating sales and controlling costs put your business in a position to do just that. But, future profits will do your company no good if it doesn’t have enough cash right now to pay its bills and stay in business. In fact, companies with no profits but a lot of cash such as a number of high-tech startups are often better off than cash-poor companies with profits. So it’s incumbent upon companies to effectively manage the cash that flows into its accounts periodically throughout the year and the cash that flows out. At the very least, your company must ensure that at all times it has enough cash in its accounts to meet short-term obligations as they come due. After all, a business can make the most innovative products and reduce expenses through the most innovative management techniques. But if it doesn’t have enough money to pay its bills, all those efforts will be for naught.

This post provides tips on how to manage company’s cash. As the title says; Four Steps to Proper Cash Management, the tips come with four steps to follow so that company’s cash properly managed [read; under control]. But before that, let’s take a look; why companies require AND desire cash. Read on…



Why Do Companies Require Cash?

Cash is a company’s most precious asset. It can be deployed in ways that fixed assets, such as land or facilities, cannot. For starters, cash can be used to meet routine, short-term obligations such as payroll, taxes, and overhead.

In fact, your company needs cash to pay for expenses throughout each of the following steps in its normal operating cycle:

  • When it buys raw materials. Obviously, your company will need cash to buy the materials necessary to manufacture its products or to deliver its services. To be sure, your company will be extended lines of credit from vendors. But to maintain those trade credits, the company must consistently pay its bills on time. Furthermore, some vendors offer discounts to companies that routinely pay their bills early.
  • When it converts those raw materials into products, through the manufacturing process. This takes labor. And labor needs to be paid. For some companies, payroll must be met weekly. Others generate paychecks every other week.
  • When it sells products. Marketing, too, requires cash. For instance, your firm needs cash to cover travel expenses and commissions for its sales force.
  • When it pays its bills. Your company will need cash to pay its bills as accounts payable come due. It will also need to meet monthly overhead costs, such as rent and utilities.


Why Do Companies Desire Cash?

In addition, cash and so-called near-cash investments like money-market mutual funds and ultra short-term bond funds, which can be liquidated quickly, may be used for longer-term, strategic purposes. Your company may use these liquid assets to:

  • Pay off long-term debts. Based on interest rates, the bond market, and the stock market, it may make sense for your company to pay down its long-term debt sooner rather than later. If it does, having access to cash will put your company at a competitive advantage.
  • Expand. A company that has an internal source of capital to help finance expansion is always better off than one that must rely solely on external sources.
  • Invest. Your company can’t take advantage of interest rates, the bond market, or the stock market if it does not have access to excess cash.
  • Protect or improve its credit rating. Banks and other lenders look to a company’s current assets to judge its creditworthiness. The more cash a company has, the better it looks.
  • Prepare for emergencies. You never know when an emergency will arise. For instance, a natural disaster may prevent a company from manufacturing or distributing its products.

 So, too, would a labor strike. Access to cash could help your company weather such events.


Which One Is Better: Too Much Or Too Little Cash?

It is challenging to think and wondering of this; if cash is so vital, why do large companies today maintain less cash on their books than they did in the past?

Fact: In 1997 the typical company in the Standard & Poor’s index of industrial companies carried about 7 percent of its assets in the form of cash or cash equivalents, compared with 10 percent a decade earlier and nearly 30 percent a half century ago.

Does this mean companies today are weaker than they were in the past? Just the opposite, the goal of cash management isn’t to hoard cash. In fact, having too much cash on hand can be just as dangerous as having too little. For instance, a company that has $1 million in excess cash actually stands to lose more than $400,000 over the course of five years. This assumes that the company could have invested that money at 7 percent a year.

So, the goal of cash management is to determine how much money a company needs based on its cash inflows and outflows, to maintain just enough, and to reduce so-called opportunity costs by investing the rest of the money at the highest rates possible for the longest periods possible. Depending on the economy and interest rates, your company may invest its excess cash in stocks or bonds. It may use the money for mergers and acquisitions. Or it may plow that money back into the company, especially if its return on investment ratios are strong. Companies may also purchase their own stock on the open market. In 1996, thanks to unprecedented cash flows, American companies had enough cash to buy back a record $176 billion worth of their own stock. The year before, companies bought back $99 billion worth of their own stock.

Now, let’s go to the main course…


Four Steps to Proper Cash Management

To properly manage its cash, then, you [as a company] must:



To determine how much working capital your company requires, it must first calculate whether its current assets will cover its current liabilities. To do this, your company relies on two of the key financial ratios: “the current ratio, in which you divide a firm’s current assets by its current liabilities to determine its liquidity”; and “the quick ratio, in which you subtract a firm’s inventory from its current assets, then divide that figure by its current liabilities to come up with a more accurate reading of liquidity”.

Current Ratio = Current Assets/Current Liabilities
Quick Ratio = (Current Assets – Inventories)/Current Liabilities

These ratios, however, are only a starting point. They tell you if a company is generally liquid. What they don’t do is project when cash is expected to flow into your company and when cash is expected to flow out. For these projections, you have to go back to your company’s cash budget.

Here are some quick back-of-the-envelope calculations to find out how much cash your company generally needs:

Calculate Your Inventory Conversion Period – Inventory conversion refers to the time it takes your company to convert raw materials into finished goods, and then to sell those goods to its customers. It can be determined by dividing your firm’s inventory by its sales per day. (Note: Don’t confuse this with inventory turnover, which is calculated by dividing sales by inventory.) For example: let’s say your company’s inventory is worth $10 million and it generates $100 million a year in sales, or $273,973 a day. By dividing $10 million by $273,973 a day, you find out that your company converts its inventory every 36.5 days.

Inventory Conversion Period = Inventory/Sales per day
Inventory Conversion Period = $10,000,000/$273,973 = 36.5 days


Calculate Your Days Sales Outstanding – Once you’ve made a sale, the Days Sales Outstanding ratio tells you how long it takes your customers to pay their bills. For instance: if your company has $15 million in receivables outstanding and generates $100 million in sales per year or $273,973 a day its Days Sales Outstanding would be 54.75 days.

Days Sales Outstanding = Accounts Receivable/Sales per day
DSO = $15,000,000/$273,973 = 54.75 days


Calculate How Long It Takes Your Company to Settle Accounts Payable – To find this out, divide your company’s accounts payable including trade credits and wages payable by the cost of goods sold per day. If, for example, your firm has $10 million in accounts payable and the cost of goods sold is $75 million (or $205,479 per day), then it turns out that your firm takes 48.667 days to pay its bills.

Accounts Payable Deferral = Accounts Payable/(Cost of Goods Sold/365 days)
Accounts Payable Deferral = $10,000,000/$205,479 = 48.667 days


Calculate Your Cash Needs – Take the number of days it takes for your company to convert its inventory and add its Days Sales Outstanding. This represents how many days it takes for your company to convert raw materials into finished goods and to sell those goods and then to receive cash for the goods it sold. In our example, the company’s inventory conversion period was 36.5 days. And it took 54.75 days to receive payment on its sales. That comes out to 91.25 days. Now, subtract the number of days it takes your company to pay its bills. In our example, the company deferred payments for 48.667 days. Subtract 48.667 days from 91.25, and the new figure 42.6 days refers to your firm’s total cash conversion cycle. The cash conversion cycle measured as inventory conversion plus Days Sales Outstanding minus accounts payable deferral refers to the amount of time your company’s cash is tied up.

Inventory Conversion: Period + Days Sales Outstanding
Accounts Payable Deferral = Cash Conversion Cycle


Step 2: COLLECTING PAYMENTS [Eight Ways to Speed Up Collections]

Each day your company is forced to wait represents another day of float. The term “float” simply refers to the time it takes your company to access its money after customers have sent in their payments. Each day of float represents another day of lost interest. In our example, your company is losing seven days of float. That’s seven fewer days the company can invest its money or seven more days it must take out loans to make up for potential cash shortfalls.

Obviously, the challenge of financial managers is to reduce float in the collection process. Here are ways your company can take right now to speed up collections:

  1. Prepare Invoices A.S.A.P – The first thing your company can do is speed up paperwork wherever possible. For instance, let’s say your firm’s computerized billing system automatically mails off invoices to customers whenever merchandise is shipped. However, it takes two working days from the time an order is placed to the time your warehouse ships the goods. By changing its billing system to issue an invoice the day an order is placed, rather than when it is shipped, your company may be able to shave two days off the collection process. Two days can mean an awful lot. For instance, let’s assume that at any given moment, your company has $100 million in accounts receivable. And let’s say it normally takes 30 days to receive payment. If you can bring that down to 28 days simply by changing your billing system, you could save your company nearly $55,600, assuming it could invest that money at 10 percent a year. That’s $100 million at .0274 percent (daily interest rate) x 2 days = $55,600.
  2. Offer Customers Incentives to Pay Sooner – Another simple method to speed up collections is to offer debtors a monetary incentive to pay sooner, rather than later. Your company can do this through positive reinforcement. For instance, it can agree to reduce interest rates on credit accounts that are paid off on time or early. Or it can use negative reinforcement. For instance, it could add penalties for late payments (although this is hard to enforce).
  3. Let Customers Pay by Credit Card – Not only is this more convenient, but both the customer and the company can enjoy the float while the credit card issuer pays the bill. However, your firm won’t recoup 100 percent of the money, due to processing fees charged by the card’s issuer.
  4. Use Pre-authorized Payments – Increasingly, businesses are offering customers an option to make preauthorized payments directly from their checking accounts. Under this system, customers don’t have to remember to write a check each month. The company is given the authority to withdraw the money directly from the account, on an agreed-upon date. To get customers to preauthorize payments, your company may have to offer an incentive, such as reduced rates. Phone companies, electric utilities, cable television companies, and insurers are among those companies adopting this system. This applies to consumer purchases; it won’t necessarily work for larger vendors.
  5. Rely On Electronic Fund Transfers – To move money quickly between banks and bank accounts, your company may want to rely on the electronic transfer of funds rather than paper checks. For instance, when your company deposits your paycheck into your bank account, it relies on something called the automated clearinghouse network. The ACH is a computerized network that allows companies to send checks electronically from one account to another. Electronic fund transfers are generally available for use by the recipient a day after authorization is given. This is about a day or two faster than the time it takes a written check to clear.
  6. Rely On Lock Boxes – Lock boxes are among the oldest and most effective methods for speeding up payment collection. Here’s how they work: Instead of relying on a centralized collection center, your company establishes several lock boxes, which are Post Office boxes or private mailboxes, throughout the country. Each lock box is administered by a third-party vendor, usually a bank. Rather than having customers mail checks to a central location, your company directs them to make payment to their nearest lock box. This generally reduces mail delivery time, or the mail float, by a day or two.
  7. Use Depository Transfer Checks – Depository transfer checks are unsigned checks used to move funds swiftly within a company. For instance, let’s say your company has several lock boxes throughout the country, each tied to a local bank account in the company’s name. To periodically pool the money into a central account, the company’s central bank is given the authority to prepare a depository transfer check that authorizes payment from the local banks to the central fund without requiring an executive’s signature.
  8. Reduce the Time It Takes to Physically Handle Checks – As checks are delivered to a company’s payment center, information on each check is used to update the company’s accounts receivable. Some companies spend a full day or two inputting this information. If your company photocopies checks as they come in, just as lock box administrators do, it can immediately deposit the actual checks into its account while inputting the data from the copies later.



When companies disburse payments, the goal is to increase float, rather than decrease it. After all, every day your company can hang on to its cash is another day it can earn interest on it. However, financial managers must be cautious. While the goal is to delay disbursement of cash, late payments can lead to fees and penalties that could easily wipe out the benefits of the float. Late payments can also adversely affect your company’s ability to receive trade credits and can damage a company’s credit ratings.

Four Ways to Legally Slow Down Payments:

  1. Centralization – An easy way to slow down payments is to centralize all disbursements. This accomplishes two things: First, it allows a financial manager at company headquarters to assess when payments should be made on all checks issued by the company. This allows the manager to physically delay payments on low-priority accounts. Second, by centralizing the process, companies often gain mail float on their payments. For instance, let’s say your company is headquartered in Boston, but has an office in Phoenix that oversees its Southwestern operations. A check sent from Phoenix to a vendor in Tucson may take one day to deliver. But if that check were issued from the company’s Boston headquarters, it could take an additional two days to deliver and an additional day or two to clear.
  2. Mail Payments toward the End of the Work Week – Here’s a nifty trick. Since banks are closed on weekends and mail service is limited, companies that mail their payments on Thursday or Friday can often earn two extra days of mail and/or processing float.
  3. Pay by Credit Card at Billing Due Date – If your company is allowed to charge its payment to a credit card, it can enjoy up to 30 days of additional float. This represents the number of days between the time the credit card issuer pays the bill and the time your company must pay the credit card issuer.
  4. Remote Disbursement – Remote disbursement is frowned upon by the Federal Reserve system and by many vendors. So it ought to be a method of last resort. Here’s how it works: Let’s say your company is based in Charlotte, NC, and owes money to a vendor in Atlanta. Instead of issuing a disbursement from its Charlotte location, it decides purpose fully to issue the payment from a satellite office in San Francisco using a California account. So, for the Atlanta vendor to gain access to the funds, it must wait for the check to travel across the country. Then, its bank must send the check back across the country to clear. While not technically illegal, the Federal Reserve has declared this is an abusive practice. Furthermore, companies that rely on this tactic run the risk of damaging their relationships with their vendors.



As you’ll recall, the purpose of managing cash is to maintain just enough to meet your obligations and to invest any excess. Before deciding how to invest that money, though, your company must first determine how much money it has to invest and how long that excess money will be available. How much cash do you have to stash? To gather this information, your company relies on its cash budget. Cash budgets indicate how much cash a company is expected to have at the beginning of each month; how much cash is expected to flow in; how much cash is expected to flow out; and what the company’s cash position is expected to be at the end of the month. In addition to how much money a company has to invest and how long it has access to those funds, where a company invests depends largely on its own tolerance for risk. For instance, the board of directors of some companies may restrict it from investing in bonds that aren’t investment grade. Investment grade bonds are rated by credit agencies as BBB (which means adequate) or higher. Cash to be held for short-term obligations can be held in the form of cash equivalents or near-term cash reserves.

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