The Importance of Cash

Reasons for Maintaining Cash on Hand

The main reason a business maintains cash on hand is to meet financial obligations.

Learning Objectives

Explain the importance for always having cash on hand

Key Takeaways

Key Points

  • Liquidity is the ability to meet obligations when they come due without incurring unacceptable losses.
  • Banks can generally maintain as much liquidity as desired, because bank deposits are insured by governments in most developed countries.
  • Banks can attract significant liquid funds to generate stronger profits, more stability, and more confidence among depositors, investors, and regulators.
  • Cash is the most liquid asset and can be used immediately to perform economic actions like buying, selling, or paying debt, and meeting immediate wants and needs.
  • Bank can attract significant liquid funds to generate stronger profits, more stability, and more confidence among depositors, investors, and regulators.

Key Terms

  • money market: A market for trading short-term debt instruments, such as treasury bills, commercial paper, bankers’ acceptances, and certificates of deposit
  • liquidity: Availability of cash over short term: ability to service short-term debt.

In business, economics, or investment, market liquidity is an asset’s ability to be sold without causing a significant movement in the price and with minimum loss of value. Money, or cash, is the most liquid asset, and can be used immediately to perform economic actions like buying, selling, paying debt, and meeting immediate wants and needs.

In bookkeeping and accounting, cash refers to current assets comprising currency or currency equivalents that can be accessed immediately or near immediately (as in the case of money market accounts). Cash is seen as a reserve for payments and as a way to meet financial obligations.

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Cash: A business’s cash account is how much currency it has on hand at a given time.

In banking, liquidity is the ability to meet obligations when they come due without incurring unacceptable losses. Managing liquidity is a daily process requiring bankers to monitor and project cash flows to ensure adequate liquidity is maintained. Maintaining a balance between short-term assets and short-term liabilities is critical. For an individual bank, clients’ deposits are its primary liabilities (in the sense that the bank is meant to give back all client deposits on demand), whereas reserves and loans are its primary assets (in the sense that these loans are owed to the bank, not by the bank). The investment portfolio represents a smaller portion of assets, and serves as the primary source of liquidity. Investment securities can be liquidated to satisfy deposit withdrawals and increased loan demand. Banks have several additional options for generating liquidity, such as selling loans, borrowing from other banks, borrowing from a central bank, such as the U.S. Federal Reserve Bank, and raising additional capital. In a worst case scenario, depositors may demand their funds when the bank is unable to generate adequate cash without incurring substantial financial losses. In severe cases, this may result in a bank run. Most banks are subject to legally mandated requirements intended to help banks avoid a liquidity crisis.

Defining the Cash Flow Cycle

The cash flow cycle measures how long it takes for a firm to recover cash that it invests in ongoing operations.

Learning Objectives

Define the cash flow cycle

Key Takeaways

Key Points

  • In management accounting, the cash conversion cycle (CCC) measures how long a firm will be deprived of cash if it increases its investment in resources in order to expand customer sales.
  • It is thus a measure of the liquidity risk entailed by growth. However, shortening the CCC creates its own risks. While a firm could even achieve a negative CCC by collecting from customers before paying suppliers, a policy of strict collections and lax payments is not always sustainable.
  • The term “cash conversion cycle” refers to the timespan between a firm’s disbursing and collecting cash.
  • Since a retailer’s operations consist of buying and selling inventory, the equation models the time between (1) disbursing cash to satisfy the accounts payable created by purchase of inventory, and (2) collecting cash to satisfy the accounts receivable generated by that sale.

Key Terms

  • balance sheet: A summary of a person’s or organization’s assets, liabilities and equity as of a specific date.
  • cash flow: The sum of cash revenues and expenditures over a period of time.
  • retail: The sale of goods directly to the consumer; encompassing the storefronts, mail-order, websites, etc., and the corporate mechanisms, branding, advertising, etc. that support them, which are involved in the business of selling and point-of-sale marketing retail goods to the public.

Cash flow cycle also is called “cash conversion cycle” (CCC). In management accounting, the CCC measures how long a firm will be deprived of cash if it increases its investment in resources in order to expand customer sales. It is thus a measure of the liquidity risk entailed by growth. However, shortening the CCC creates its own risks: while a firm could even achieve a negative CCC by collecting from customers before paying suppliers, a policy of strict collections and lax payments is not always sustainable.

Cash Conversion Cycle

The cash conversion cycle refers to the time frame between a firm’s cash disbursement and cash collection. However, the CCC cannot be directly observed in cash flows, because these are also influenced by investment and financing activities; it must be derived from statement of financial position or balance sheet data associated with the firm’s operations.

Retail

Although the term “cash conversion cycle” technically applies to a firm in any industry, the equation is formulated to apply specifically to a retailer. Since a retailer’s operations consist of buying and selling inventory, the equation models the time between the following:

  1. Disbursing cash to satisfy the accounts payable created by purchase of inventory; and
  2. Collecting cash to satisfy the accounts receivable generated by that sale.

The CCC must be calculated by tracing a change in cash through its effect upon receivables, inventory, payables, and finally back to cash, thus, the term cash conversion cycle, and the observation that these four accounts “articulate” with one another.

The equation describes a firm that buys and sells on account. Also, the equation is written to accommodate a firm that buys and sells on account. For a cash-only firm, the equation would only need data from sales operations (e.g., changes in inventory), because disbursing cash would be directly measurable as purchase of inventory, and collecting cash would be directly measurable as sale of inventory.

However, for a firm that buys and sells on account, Increases and decreases in inventory do not occasion cash flows but accounting vehicles (receivables and payables, respectively); increases and decreases in cash will remove these accounting vehicles (receivables and payables, respectively) from the books.

Calculating the Cash Flow Cycle

Cash flow cycle = # days between disbursing cash and collecting cash in connection with undertaking a discrete unit of operations.

Learning Objectives

Calculate a company’s cash flow cycle

Key Takeaways

Key Points

  • Cash flow cycle = Inventory conversion period + Receivables conversion period – Payables conversion period.
  • Inventory conversion period = Avg. Inventory / (COGS / 365); Receivables conversion period = Avg. Accounts Receivable / ( Credit Sales / 365); Payables conversion period = Avg. Accounts Payable / (Purchases / 365).
  • There are five important intervals, referred to as conversion cycles (or conversion periods).
  • Our aim of studying cash conversion cycle and its calculation is to change the policies relating to credit purchase and credit sales.

Key Terms

  • Credit Sales: Credit Sales are all sales made on credit.

Cash Flow Cycle

The cash flow cycle is also called cash conversion cycle (CCC).

CCC=# days between disbursing cash and collecting cash in connection with undertaking a discrete unit of operations.

=Inventory conversion period + Receivables conversion period – Payables conversion period

Inventory conversion period = Avg. Inventory / (COGS / 365)

Receivables conversion period = Avg. Accounts Receivable / (Credit Sales / 365)

Payables conversion period = Avg. Accounts Payable / (Purchases / 365)

There are five important intervals, referred to as conversion cycles (or conversion periods):

  • The Cash Conversion Cycle emerges as interval C→D (i.e., disbursing cash→collecting cash).
  • The payables conversion period (or “Days payables outstanding”) emerges as interval A→C (i.e., owing cash→disbursing cash)
  • The operating cycle emerges as interval A→D (i.e., owing cash→collecting cash)
  • The inventory conversion period or “Days inventory outstanding” emerges as interval A→B (i.e., owing cash→being owed cash)
  • The receivables conversion period (or “Days sales outstanding”) emerges as interval B→D (i.e., being owed cash→collecting cash)

Knowledge of any three of these conversion cycles permits derivation of the fourth (leaving aside the operating cycle, which is just the sum of the inventory conversion period and the receivables conversion period. )

Hence, interval {C → D}=interval {A → B}+interval {B → D}–interval {A → C}

In calculating each of these three constituent conversion cycles, we use the equation TIME =LEVEL/RATE (since each interval roughly equals the TIME needed for its LEVEL to be achieved at its corresponding RATE).

We estimate its LEVEL “during the period in question” as the average of its levels in the two balance sheets that surround the period: (Lt1+Lt2)/2.

To estimate its RATE, we note that Accounts Receivable grows only when revenue is accrued; and Inventory shrinks and Accounts Payable grows by an amount equal to the COGS expense (in the long run, since COGS actually accrues sometime after the inventory delivery, when the customers acquire it).

  • Inventory conversion period: Rate = COGS, since this is the item that (eventually) shrinks inventory.
  • Receivables conversion period: Rate = revenue, since this is the item that can grow receivables (sales).
  • Payables conversion period: Rate = [inventory increase + COGS], since these are the items for the period that can increase “trade accounts payables” (i.e., the ones that grew its inventory).

Aims of CCC

Our aim of studying cash conversion cycle and its calculation is to change the policies relating to credit purchase and credit sales. We can change our standard of payment of credit purchase or getting cash from our debtors on the basis of reports of cash conversion cycle. If it tells good cash liquidity position, we can maintain our past credit policies. Its aim is also to study cash flow of business. Cash flow statement and cash conversion cycle study will be helpful for cash flow analysis.

Components of the Cash Budget

The cash budget includes the beginning balance, detail on payments and receipts, and an ending balance.

Learning Objectives

Identify the different components of a cash budget

Key Takeaways

Key Points

  • The cash flow budget helps the business determine when its income will be sufficient to cover its expenses and when the company will need to seek outside financing.
  • Components – major classes include cash receipts and payments.
  • Cash receipts include cash generated from operations, cash receipts from customers, proceeds from the sale of equipment, dividends received, and other income.
  • Cash payments include cash paid to suppliers, cash paid to employees, purchase of assets, payments related to mergers and acquisitions, interest paid, income taxes paid, dividends paid, and other payments.

Key Terms

  • stockholders: A shareholder or stockholder is an individual or institution (including a corporation) that legally owns a share of stock in a public or private corporation.
  • mergers and acquisitions: Mergers and acquisitions (abbreviated M&A) is an aspect of corporate strategy, corporate finance, and management dealing with the buying, selling, dividing and combining of different companies and similar entities that can help an enterprise grow rapidly, whether in its sector or location of origin, or a new field or new location, without creating a subsidiary, other child entity, or using a joint venture.

Cash Budget

A cash budget is a prediction of future cash receipts and expenditures for a particular time period, usually in the near future. The cash flow budget helps the business determine when its income will be sufficient to cover its expenses and when the company will need to seek outside financing.

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A Sample Balance Sheet: One of the assets listed is cash, which factors into the overall budget.

Components: Major classes include cash receipts and payments.

Cash Balance, Beginning of the Year

Cash Receipts

  1. Cash generated from operations
  2. Cash receipts from customers – Collecting the accounts receivable. Accounts receivable, also known as Debtors, is money owed to a business by its clients (customers) and shown on the business’s balance sheet as an asset. It is one of a series of accounting transactions dealing with the billing of a customer for goods and services that the customer has ordered.
  3. Proceeds from the sale of equipment
  4. Dividends received: Dividends are payments made by a corporation to its shareholder members. It is the portion of corporate profits paid out to stockholders. When a corporation earns a profit or surplus, that money can be put to two uses: it can either be re-invested in the business (called retained earnings), or it can be distributed to shareholders.
  5. Other income: Other investment or other interest income, etc.

Cash Payments

  1. Cash paid to suppliers
  2. Cash paid to employees – Salary, wages expenses.
  3. Purchase of asset – Equipment, machine, real estate, etc.
  4. Payments related to mergers and acquisitions
  5. Interest paid – Interest of short-term or long-term debt.
  6. Income taxes paid
  7. Dividends paid – Paying dividends to shareholders or investors.
  8. Debt paid – Short term or long term debt principle.
  9. Other payment – Which includes Advertising, Selling expenses, Administrative expense, Insurance expenses, Rent expenses, etc.

Net increase in cash and cash equivalents

Cash balance, end of year