What is Cash Management? Definition, Importance & Functions

Managing available capital is crucial for the survival of a small business. Cash management, a fundamental aspect of business operations, involves efficiently handling the company’s cash. This includes overseeing bank accounts, ensuring adequate funds for short-term requirements, and making prudent investment decisions. Effective cash management enables a business to meet its financial obligations, avoid excessive debt, and utilise capital wisely for expansion. Daily, it entails practical tasks such as monitoring cash flow, tracking outstanding payments and bills, and utilising financial tools to manage funds effectively. For small businesses and startups, this involves adhering to budgets, expediting receivables, closely scrutinising expenses, setting aside funds for unforeseen circumstances, and making informed investment choices.

This blog explores cash management, how it works, its importance, functions and different strategies.

What is Cash Management?

Cash management involves overseeing the collection, management, and investment of funds. This includes managing bank accounts, ensuring enough liquidity to meet short-term obligations, optimising cash flows, and making strategic investment decisions.

By effectively managing cash, a business can meet its financial obligations, avoid excessive debt, and strategically utilise its cash resources for growth and stability. This includes practices like forecasting cash flow, managing receivables and payables, and using tools and strategies to optimise the handling of cash inflows and outflows.

Business cash management encompasses handling account payables and receivables from various investing, financing, and operating sources. It is a multifaceted and intricate process involving multiple stakeholders, various timelines, and significant amounts of money.

How Cash Management Works?

Cash management involves overseeing a company’s funds to ensure enough money is available to meet its financial obligations. This includes keeping track of money coming in and going out, predicting future cash needs, and deciding how to invest extra cash to make more money. Effective cash management is crucial for a company’s financial stability.

The steps involved in cash management:

1. The first step is to develop a cash budget, which involves forecasting cash inflows and outflows. This budget provides a detailed picture of expected cash movements, helping to anticipate periods of surplus or deficit.
2. Next, implement cash-flow management strategies, like offering discounts for early payment.
3. Create a cash management strategy, such as negotiating payment terms with suppliers to extend payment periods without damaging relationships. This helps manage outflows more effectively and ensures that cash is available.
4. If excess cash is available, invest in low-risk, short-term instruments such as short-term government securities or money market funds. These investments provide a balance between safety and accessibility,
5. Review the cash position regularly to make timely adjustments to the cash management plan. This might include reallocating funds, revising budgets, or altering investment strategies based on current financial conditions and future forecasts.

Importance of Cash Management

The importance of cash management is as follows:

• Ensuring Business Continuity: Maintaining an adequate amount of cash is essential for the seamless operation of any business. A business is reliant on cash to facilitate daily activities such as purchasing supplies, compensating employees, and meeting other financial obligations. Depletion of cash reserves can result in operational halts or slowdowns, potentially causing significant complications. Effective cash management practices are imperative to guarantee a consistent cash flow that sustains uninterrupted business progression.
• Improving Investment Opportunities: Effective cash flow management can result in a business’s surplus of funds. This surplus cash can be strategically invested in short-term or long-term financial instruments such as stocks and bonds to generate additional income. The returns from these investments can significantly contribute to the business’s growth and profitability in the long run.
• Enhancing Creditworthiness: Maintaining effective cash management is essential for businesses as it demonstrates their ability to handle finances responsibly. It reduces the risk for lenders and investors, showing that the business can meet its financial obligations. As a result, lenders may offer loans at lower interest rates, while investors may show greater interest in providing capital. Enhanced creditworthiness from good cash management can offer significant advantages when the business needs to secure financing or raise capital.
• Reducing Borrowing Costs: Efficient cash management can minimise the need for a business to borrow money by optimising the use of existing cash. When borrowing is necessary, good cash management practices help the business choose the most favourable times and terms for borrowing, potentially securing lower interest rates. This reduces the cost of borrowing, allowing the business to save on interest and fees. Lower borrowing costs improve the business’s financial health, freeing up more cash for investments or other strategic uses.

Managing Cash Through Internal Controls

Companies use various internal controls to manage cash flow and ensure smooth business operations effectively. Internal controls refer to accounting and auditing measures that help businesses comply with financial regulations. These tools, resources, and procedures enhance operational efficiency and reduce the risk of fraud.

Key considerations for managing cash flow include:

• The average time it takes to collect accounts receivable (AR)
• The efficiency of collection processes
• Handling write-offs for uncollected receivables
• Managing liquidity and ensuring favourable rates of return on cash-equivalent investments
• Overseeing credit lines
• Maintaining adequate levels of operating cash

These factors are crucial for maintaining healthy cash flow and ensuring the financial stability of a business.

Cash Management of Working Capital

Cash flow from operating activities is closely tied to working capital, which is influenced by changes in accounts receivable (AR) and accounts payable (AP). In contrast, cash flows from investing and financing activities usually involve extraordinary events that require special financial procedures.

Working capital is calculated by subtracting a company’s current liabilities from its current assets. It plays a crucial role in cash flow management, indicating how well a company can cover its short-term obligations with its available assets.

Working capital typically includes:

• Current Assets: Cash, accounts receivable due within one year, and inventory
• Current Liabilities: All accounts payable due within one year and short-term debt payments due within the same period

Companies aim to have more current assets than current liabilities. If current liabilities exceed current assets, the company might need to use its reserve credit lines to cover its payables.

Changes in working capital are usually reported in the operating section of the cash flow statement from one reporting period to the next. A positive change in working capital means the company has increased its current assets to cover its liabilities, boosting its total cash. Conversely, a negative change indicates an increase in current liabilities, which can reduce the company’s ability to pay them efficiently and lower its total cash.

To improve the efficiency of both receivables and payables, and thus enhance working capital and operating cash flow, companies can take several steps. Those that rely on invoicing can shorten payment terms or offer discounts for early payments. They may also adopt technologies that facilitate faster and easier payments, such as automated billing and electronic payment systems.

Advanced technology can also streamline payables management. Companies might opt for automated bill payments or direct payroll deposits to improve efficiency and reduce the cost of managing payables.

Cash Management Services

Cash management services are specialised financial offerings banks and financial institutions provide to help businesses effectively manage their daily finances. These services enhance cash flow, ensuring sufficient funding for expenses while maximising surplus funds.

Through the use of tools such as automated collections and disbursements, businesses can enhance their operational efficiency and allocate more time to other important tasks. Ultimately, the goal of cash management services is to help companies achieve better returns by efficiently managing available cash and investing any excess funds for optimal returns.

Cash Management and Solvency Ratios

In cash management, companies regularly monitor and analyse liquidity and solvency ratios. These ratios are also important to external stakeholders for various analytical purposes. The two main liquidity ratios used in cash management are the quick ratio and the current ratio.

The quick ratio is calculated as follows: Quick Ratio = (Cash Equivalents + Marketable Securities + Accounts Receivable) ÷ Current Liabilities

The current ratio offers a more comprehensive view and is calculated as: Current Ratio = Current Assets ÷ Current Liabilities

Solvency ratios assess a company’s ability to meet its long-term obligations. Popular solvency ratios include debt to equity, debt to assets, cash flow to debt, and the interest coverage ratio. These ratios provide valuable insights into a company’s financial health and its capacity to sustain operations over the long term.

Benefits of Cash Management

The following are the benefits of cash management:

• Data-Driven Forecasting and Planning: With a comprehensive cash management system, businesses can leverage precise financial data to forecast future expenses and profits. This allows them to make strategic and well-informed plans, ensuring optimal allocation of resources and sustainable growth.
• Enhanced Control and Visibility: Cash management tools offer comprehensive visibility into the inflow and outflow of funds, enabling users to track the sources of income and destinations of expenses meticulously. By leveraging these tools, individuals and businesses can effectively identify opportunities for optimisation, enabling them to make well-informed decisions about their financial activities, including spending and saving strategies.
• Increased Efficiency and Reduced Risk: One key benefit of cash management services is the ability to automate various tasks such as bill payments, collections, and reconciliation. Automating these processes saves time for both businesses and individuals, enabling them to concentrate on their primary activities. Furthermore, automation helps minimise human errors, lowering the chances of financial discrepancies or losses. This enhanced efficiency results in smoother financial operations and more precise financial records.
• Improved Liquidity: It is important to manage cash effectively to ensure that businesses and individuals have enough cash on hand to cover expenses and take advantage of opportunities as they come up. By managing cash flow efficiently, these services help maintain a balance between having enough cash available and making smart investments. This ensures that money is always available when needed, whether for day-to-day expenses, unexpected situations, or long-term investments.
• Lowered Risk: Optimizing financial procedures and decreasing dependence on physical cash management can substantially reduce costs. Cash management services help mitigate the potential risks linked with cash transactions, including theft and mishandling. Organisations can safeguard resources and uphold financial security by utilising digital resources and secure transaction techniques.
• Simplified Compliance: Cash management services offer tools and reports that streamline the compliance process, making it easier for businesses to adhere to financial regulations. These services provide automated reporting, audit trails, and compliance checks, which are especially helpful for companies operating in industries with strict regulatory requirements. By using these services, businesses can reduce the burden of compliance and minimise the risk of regulatory violations.

Limitations of Cash Management

The limitations of cash management are as follows:

• Poor Cash Flow Management: Managing cash flow effectively is a big challenge. Companies need to closely track when they receive and spend money to make sure they always have enough to pay their bills. Without careful oversight and planning, businesses might struggle to match the timing of money coming in and going out, which could lead to financial problems.
• Delayed Collection of Cash: Companies may face cash flow issues when they recognize revenue at the time of a transaction but experience delays in actually receiving the money, which can take up to 90 days. This means that even though a company may report high profits based on its revenue, it may still have cash deficits if it encounters delays in collecting payments. This situation can create cash flow problems, even for businesses that are profitable on paper.

Types of Cash Management

The types of cash management are as follows:

Cash Flow from Operating Activities

Cash flow from operating activities refers to the cash transactions associated with a company’s core business operations. This includes cash inflows and outflows generated by the company’s primary activities, such as sales of goods or services, payments to suppliers, wages to employees, and other operational expenses. This type of cash flow is essential because it shows the company’s ability to generate enough cash to sustain and expand its operations. It does not include cash flows from investing and financing activities.

Free Cash Flow to Equity (FCFE)

Free cash flow to equity is a crucial financial metric that shows the cash available to a company’s shareholders after accounting for capital expenditures and debt repayments. It represents the cash reserve left after reinvesting the capital needed to maintain or expand the business. FCFE is an essential indicator of a company’s financial health and ability to return cash to its equity investors through dividends or share buybacks.

Free Cash Flow to the Company (FCFF)

Unlevered free cash flow, or free cash flow to the firm, is the cash that a company generates from its operations after deducting operating expenses, taxes, and capital expenditures but before taking into account interest payments and debt repayments. This metric is important for financial analysis and evaluating a company’s profitability because it indicates the cash available to all investors, including debt and equity holders.

Net Change in Cash

The net change in cash is a measure that reflects the total change in a company’s cash position between two accounting periods. It considers all cash inflows and outflows from operating, investing, and financing activities. This measure offers a holistic perspective on how the company’s cash balance has developed over the period and is crucial for assessing the company’s liquidity and cash management effectiveness.

Functions of Cash Management

The following are the functions of cash management:

• Inventory Management: Effective inventory management is essential for unblocking trapped sales and reducing excess stock. High levels of inventory can tie up a company’s funds, leading to decreased liquidity. Businesses can ensure a steady cash inflow by managing funds effectively and clearing out existing stock.
• Receivables Management: Following a credit sale, the company typically records the transaction as a sale in its accounting records. However, the payment for the sale is often pending. Effective cash management is crucial in ensuring that all outstanding bills and receivables are promptly paid to prevent any shortage of liquid cash within the company.
• Payables Management: Payables refer to the amount a company owes for purchases made on credit. In some cases, organisations may take out loans from banks or other lending institutions and must repay the amount within a specific timeframe. Therefore, effective fund management is crucial to ensure timely repayment and avoid incurring penalties or additional interest charges.
• Short-Term Investment: Cash management is a critical aspect of financial operations, focusing on preventing cash shortages and insolvency. Additionally, it involves strategic investments in shorter-term instruments, such as government securities, to maximise the value of funds.

Objectives of Cash Management

The objectives of cash management are as follows:

• Controls Cash Flow: An effective cash management system is crucial for controlling cash outflow and increasing cash inflow in a business. By minimising cash outflow, businesses can reduce operational expenses while aiming to boost cash inflow. Integrating a cash management system with software can provide real-time cash visibility, giving businesses better control over their cash flow.
• Efficient Cash Planning: Effective cash management is crucial for optimising cash flow and planning capital expenditure. Businesses can acquire finances strategically by determining the right ratio of equity and debt. Organisations can ensure they have sufficient liquid cash to meet their financial obligations with proper planning.
• Meet Unforeseen Expenses: Maintaining surplus cash reserves can give the company the financial flexibility to effectively address and overcome unexpected circumstances, such as machinery breakdown. This approach allows the company to minimise disruption to its operations and maintain continuity in serving its customers and fulfilling its obligations.
• Ease of Investment: Cash management is a crucial aspect of financial strategy that focuses on efficiently using available funds by maintaining a balance between cash reserves and investments. This allows for investing idle funds appropriately when the right opportunity arises, which is a key goal of cash management.
• Avoiding Insolvency: Without effective cash flow planning and monitoring, businesses may be unable to meet their financial obligations. This can happen when there is insufficient liquid cash to cover expenses or when the company fails to generate profits from its available funds. In such scenarios, the company may struggle to pay its bills and maintain its operations, leading to potential financial distress.

Ways to Improve Cash Management

Some ways that cash management can be improved are as follows:

• Create a comprehensive cash flow forecast to manage future cash inflows and outflows effectively.
• Optimise billing and collections processes to reduce the time needed to receive payments.
• Monitor and control expenses to minimise cash outflows.
• Enhance cash flow by negotiating better payment terms with suppliers.
• Utilise technology, such as online payment systems, to streamline payment processes.
• Establish a cash reserve to maintain liquidity for unexpected expenses or revenue shortfalls.
• Implement a centralised cash management system to improve cash balance and transaction visibility.
• Review and update cash management policies and procedures regularly to ensure they remain effective and efficient.
• Consider short-term investments, such as money market funds, to earn returns on excess cash.
• Conduct regular audits of cash management practices to identify areas for improvement and ensure compliance with regulations.

Basic Principles of Cash Management

The two basic principles of cash management are as follows:

• Accelerating the Cash Receivables Process: Encouraging clients and customers to pay their bills on time is essential for companies. Offering attractive discounts and other incentives can motivate them to do so. By speeding up the cash receivables process, businesses can improve their cash flow and reduce the time it takes to convert sales into cash.
• Keeping Inventory Levels Low: Maintaining a high level of inventory can unnecessarily tie up cash and valuable warehouse space. Companies must develop effective techniques and strategies to keep inventory levels low.

Cash Management Strategies

Some of the cash management strategies are as follows:

Cash Forecasting and Budgeting

Businesses need to forecast their cash inflows and outflows and establish a budget. This practice helps them effectively manage their cash flow and prepare for any potential shortages. By taking a proactive approach, companies can anticipate future financial requirements and prevent liquidity crises.

Negotiating Payment Terms

Negotiating advantageous payment terms with both customers and suppliers can have a significant impact on cash flow management. For instance, businesses can provide early payment discounts to customers to speed up receivables or negotiate extended payment terms with suppliers to defer outflows.

Efficient Billing and Collection Process

Improving the billing and collection process can help businesses get paid faster and convert accounts receivable into cash more efficiently. Streamlining these processes can lead to better cash flow and lower the risk of cash shortages.

Minimise Expenses

Reducing unnecessary expenses is a crucial strategy for conserving cash and improving cash flow. Businesses can achieve this by negotiating better prices from suppliers, implementing cost-cutting measures, and regularly reviewing expenses to identify and eliminate waste.

Maintain Adequate Cash Reserve

Businesses need enough cash on hand to cover unexpected expenses, handle emergencies, and take advantage of unforeseen opportunities. By keeping extra cash available, businesses can ensure they have the money they need to deal with unexpected challenges and pursue growth opportunities.

Conclusion

Proper cash management is crucial for businesses to address financial challenges, ensure smooth operations, and seize growth opportunities. These techniques are instrumental in addressing financial challenges efficiently. Cash management strategies should be tailored to suit each business’s specific needs and characteristics. Different managers may have varying goals for the future of their businesses, leading to diverse approaches to cash management.

Frequently Asked Questions