Corporate Finance

Cash Management

Cash ManagementMost companies hold some of their assets in cash – even though cash earns no interest. Why hold cash instead of investing it in promising projects or short-term securities? Of course, one reason for holding cash is to pay for goods, services and wages. A company might prefer to pay its employees with short-term government bonds but that simply wouldn’t be practical. The main reason for holding cash is to facilitate the payments and collections for the regular activities of the firm. Cash inflows (collections) and outflows (payments) are not perfectly synchronized. Some cash holdings are necessary as a buffer.

Given that carrying cash has a cost, the objective of cash management is for the firm to hold as little cash as possible while still operating effectively and efficiently. Three important aspects of cash management are:

  1. Finding the target cash balance
  2. Collecting and paying cash efficiently
  3. Investing excess cash

Finding the Target Cash Balance

Holding too little cash might mean running into difficulty paying suppliers and workers. It could mean being forced to sell other assets or borrowing, which comes at a cost. The cost of holding too much cash is that it just sits in the back account, collecting little or no interest, instead of being put to work to generate more cash.

Larger firms sometimes use mathematical models to estimate the ideal casn range to hold
(if you’re curious about some of these models, do a search for the “Baumol” and “Miller-Orr” models) .

For smaller firms, a more practical approach starts with a cash budget, as outlined in our article on short-term financial planning. It helps determine when cash short-falls might happen. Experience also plays a large role when setting a lower cash limit.

Collecting and Paying Cash Efficiently

The traditional way of receiving payments is to first mail out an invoice, wait for a check to arrive, depositing the check at a bank, and waiting for the check to clear. This process can take days or weeks.

More recently, electronic payment systems have been introduced that can speed up payment processing dramatically. Electronic data interchange (EDI) is the general term used to refer to the practice of direct, electronic information exchange between businesses. EDI allows for the seller to bill the buyer electronically, let the buyer authorize payments, and have funds transferred. This allows businesses to avoid the postal system completely. Another advantage of EDI, is that payments to suppliers can be made right on, or just before, the due date more easily. There’s no need to estimate mail transit times.

Older EDI systems were expensive and complicated to set up. Today, with the growth of the Internet this has changed. E-commerce systems that allow for online transactions have become affordable even for small businesses.

Investing Surplus Cash

Instead of leaving cash idle in a checking bank account that pays no interest, why not make some relatively safe, short-term (money market) investments?

Many large companies manage their own short-term financial assets, transacting through investment dealers and banks. Smaller companies often use third parties for a management fee. The fee is compensation for the fund manager’s professional expertise. Banks will often have short-term investment options available for their business customers. This is a convenient (and relatively safe) way for a smaller business to invest idle cash.