Why Cash Management Is Key To Business Success

Cash is the lifeblood of a business, and a business needs to generate enough cash from its activities so that it can meet its expenses and have enough left over to repay investors and grow the business. While a company can fudge its earnings, its cash flow provides an idea about its real health.

Cash is King

By generating enough cash, a business can meet its everyday business needs and avoid taking on debt. That way, the business has more control over its activities. In a situation in which a business has to take on debt to meet its expenses, it is likely that its debtors will have a say in how the business is run. If they have contrary opinions to the management’s, that could be an impediment to the way management executes its vision for the business.

Without generating adequate cash to meet its needs, a business will find it difficult to conduct routine activities such as paying suppliers, buying raw materials, and paying its employees, let alone making investments. And it should have sufficient cash to pay dividends and keep its investors happy. Some companies also use their cash to engage in share buybacks to reward investors.

Improving Cash Management

Even if a company is making a profit by making more revenue than it incurs in expenses, it will have to manage its cash flow correctly to be successful. A company’s cash flow is tied to its operations or business activities, to its investment activities (such as the purchase or the sale of capital equipment), and to its financing activities (such as raising debt or equity funding or repaying such funding). The cash that a company generates from its operations is tied to its core business activities and provides the best opportunities for cash flow management.

Areas that offer possibilities for better cash management include accounts receivable, accounts payable, and inventories. If a company were to grant credit indiscriminately, without ascertaining the creditworthiness of its customers, and not follow up on tardy payments, that would lead to a slower and smaller inflow of cash, as well as unpaid bills. That is why it is important to have a credit policy and follow up on tardy payments. On the other hand, when it comes to accounts payable, it is a better approach to cash management to pay suppliers later rather than earlier. As well, it is important not to have too much cash tied up in inventories but to have on hand just enough inventories for the immediate needs of the business.

Striking the Right Balance

There is a balance between having too much cash on hand, out of precaution, and having an inadequate supply. If a business has too much cash, it is missing out on opportunities to invest the cash and generate additional earnings. On the other hand, if it doesn’t have an adequate supply of cash, it will have to borrow the money and pay interest or sell off its liquid investments to generate the cash it needs. If the business expects to generate a better return on its investments than it pays in interest on its borrowings, it might decide to invest its surplus cash and borrow any additional money it needs for its activities. In analyzing a company’s balance sheet, certain ratios such as a firm’s acid-test ratio or the ratio of its most liquid current assets (including cash, accounts receivable, and marketable securities) to its current liabilities provide an idea about its cash management. While a ratio of greater than one indicates a healthy current assets situation, a very high ratio could indicate that the firm holds too much cash or other liquid assets.