Cash Management

1 Introduction

You might have come across the saying ‘Cash is King’, and in business, it is. Organisations can exist for a long time even if they make losses. If they can raise capital from a bank, or from investors in shares, or the government, or by selling assets, they will survive. But businesses that are long-term unprofitable will eventually find it impossible to raise more capital and they will run out of cash. Once the organisation cannot pay its employees, its suppliers, its landlord, its interest or its tax it will have to stop trading.

What cash means

Cash means notes and coins in hand, the balance on the current account at the bank, and deposits that can be turned back into money on demand or at very short notice without losing value. An overdraft is negative cash. A receivable is not cash, however certain it looks, and neither is inventory — both are things you hope will become cash.

A cash flow is a receipt or a payment of that cash, recorded in the period in which the money actually moves. That is what separates it from income and expenditure, which are recorded when the sale is made or the cost incurred. A credit sale in March that is paid for in May is income in March and a cash inflow in May — and it is the gap between those two dates that ruins businesses.

2 Profit v cash

Profits are usually calculated using the accruals basis. So, a sale will count as income as soon as it is made even though the customer might not pay for a month or so.

Cash movements are not necessarily caused by profit and loss account items. For example, buying non-current assets, paying dividends and repaying loans are not expenses to be deducted from the profit and loss account, but they do deplete cash.

Unfortunately it is often relatively inexperienced but successful businesses that run out of cash. They might be expanding rapidly by buying equipment (cash spent), and fail to budget properly for future cash needs. A business can be profitable but can have net negative cash flows.

Receipts and payments

Before you can forecast cash you have to know where it comes from and where it goes. It helps to sort the flows two ways: by what causes them, and by whether they are regular or exceptional.

Regular flows repeat every month and can be forecast from experience. Exceptional flows happen once, are usually large, and are the ones that catch a business out — a tax bill or a machine purchase falling in the same month as a quiet period for sales.

In a sole trader or partnership, drawings are a payment too. The owner takes cash out of the business for private living expenses. Drawings are not an expense and never appear in the statement of profit or loss, but they leave the bank account just as surely as wages do and must be budgeted for.

3 Cash flow budgets

Cash flow budgets (or forecasts) are essential for successful cash management. The secret is to get the timing correct.

The objectives of a cash budget

A cash budget is prepared for five reasons, and you should be able to state them.

• To see a shortage coming in time to do something about it. Arranging an overdraft three months early is a conversation; asking for one the day the wages are due is a crisis, and an expensive one.
  

• To spot surpluses, and for how long they will last, so the money can be put on deposit at a decent rate instead of sitting idle in a current account.
  

• To set a target against which the actual cash position can be monitored during the period.
  

• To test a plan before committing to it. If the budget shows that the planned expansion cannot be funded, it is far cheaper to find that out on paper.
  

• To coordinate the rest of the budgets. The sales, production, purchasing and capital expenditure budgets all end up as cash at some point, and the cash budget is where it becomes clear whether they are affordable together.
  

A second, shorter cash budget

Work down the same four lines every time: receipts, payments, net cash flow for the month, and the balance carried forward. Then put the balance carried forward from one month into the balance brought forward of the next. Put each amount in the month the money moves, not the month the sale or the cost belongs to.

The business is profitable in every one of those months, and it still goes $2,000 overdrawn at the end of March — because the machine is paid for before March's sales are collected. Knowing that in January, the business can arrange a small overdraft, delay the machine by a month, or ask the supplier for credit. Knowing it in March, it has no good options left.

Using the cash budget to monitor and control

Preparing the budget is planning. Control starts once the period begins: at the end of each month the actual cash figures are set beside the budgeted ones, line by line, and the differences are explained.

That diagnosis leads to action, and the action is what control means: chase the overdue accounts, tighten the credit terms, and — just as important — change the assumption in the forecast for the rest of the year, because a one-month collection period is evidently no longer true.

Most businesses therefore run a rolling cash forecast. Each month the month just gone is dropped, a new month is added at the far end, and the remaining months are re-forecast in the light of what actually happened. The business always has twelve months of cash visibility ahead of it instead of watching the horizon get closer as the year goes on.

4 The working capital cycle

Some of what you see in the cash flow forecast is the working capital cycle. This can be depicted as:

Cash is tied up in inventory and (raw material, work-in-progress, and finished goods). It is then tied up for a period in receivables. After some time, cash has to be paid to suppliers. The cycle repeats.

The cycle length can be calculated as:

Days of inventory + Receivables collection period – Payables payable period.

The longer the working capital cycle, the more working capital the organisation needs to be able to trade. Organisations differ greatly in this regard. For example:

Supermarkets: the days of inventory will be low as food is perishable. Therefore cash is not tied up in inventory very long – perhaps 5 days on average. There are no credit customers, so cash is received immediately for sales. Receivables collection = 0. Supermarkets will take 30 – 60 days credit (say) from suppliers.

Working capital cycle = 5 + 0 – 30 = -25. So supermarket’s working capital is self-funding as they get cash in before they have to pay it out.

Engineering company: assume days of inventory = 90; receivables collection period = 40 days and suppliers have to be paid after 30 days.

Working capital cycle = 90 + 40 – 30 = 100 days

So, engineering firms are ‘out of pocket’ for 100 days and this has to be funded by raising capital.

Anything a company can do to reduce its working capital cycle length will improve its position. So they should concentrate on reducing inventory, negotiating better terms from suppliers and encouraging customers to pay more quickly.

5 Treasury management

Treasury management can be defined as:

“The management of an organisation’s investments and cash flows, its banking, money market and capital market transactions; the control of the risks associated with those activities, and the pursuit of optimum returns consistent with those risks”.

Some terms need to be expanded on here:

Money market:   where money can be placed on deposit or borrowed from. The main participants are banks but other organisations such as insurance companies and local councils can be involved also.

Capital market:   for example, the stock exchange. Shares can be issued here to raise cash.

Risks and returns:   these go hand in hand. If money is put into a risky investment then the depositor would expect a higher return. Generally, the longer the term of a deposit, the higher the interest rate that will be obtained. The borrower knows that the cash doesn’t have to be repaid for some time (so will pay more) but the lender is locked in for a longer time so will demand higher interest in exchange for flexibility and the risk that the money will be needed earlier.

The aims of treasury management are to try to ensure that

• no cash is lost through poor investments
  

• investments are timed to prevent the need for short term, emergency borrowing
  

• borrowing is planned and taken at the best time and only for as long as necessary
  

• the most efficient use is made of surplus cash

6 Cash in public sector organisations

A government department, a local authority, a state hospital or a state school is holding public money, and the rules it works under are tighter than those of a company. The detail varies from country to country, but the principles are the same everywhere and those are what you need.

• Security first, then liquidity, then yield — in that order. A public body's first duty is not to lose the money, its second is to have it available when it is needed, and earning a return comes last. A company may take a calculated risk for a better rate; a public body may not.
  

• No speculation. Public funds may not be invested to make a profit from movements in interest rates, exchange rates or share prices. Investment is for the safekeeping of money that will be spent, not for trading.
  

• Approved counterparties only. Surplus cash may be placed only with institutions on an approved list, usually built from credit ratings, with a maximum amount and a maximum period set for each one so that no single failure can cause serious loss.
  

• A treasury management policy approved and published in advance. The elected members or the governing board approve a strategy for the year setting out what may be invested in, with whom, for how long and up to what limits, and they receive reports during the year and an outturn report afterwards.
  

• Statutory borrowing and investment limits. Legislation typically caps how much a public body may borrow, restricts what it may borrow for (capital projects, not day-to-day running costs), and requires borrowing to be affordable and prudent.
  

• Public accountability. Balances and investments are reported publicly, audited by an external auditor appointed under statute, and open to scrutiny in a way a company's treasury decisions are not.
  

The practical effect is that a public sector treasurer has much less room than a company treasurer. Faced with a surplus for six months, a company might weigh a higher-yielding deposit against the risk; a public body will place it with an approved counterparty at a lower rate, within its published limits, and record why.

7 Raising capital

There are two main sources of capital: share capital and loan capital. This syllabus does not deal with share capital.

Most businesses will raise loan capital from a bank and this is typically divided into four types of capital:

• Overdrafts:   repayable on demand and short term loans : usually < 1 year
  

• Medium term loans:   typically 1 – 5 years
  

• Long term loans:   typically >5 years
  

Generally companies are advised to raise loans that match the life of the asset being bought or funded by the loan. This is similar to what happens in personal finance:

If you were buying an apartment a long term loan (‘mortgage’) of around 25 years would be used.

If you were buying a car, a medium term loan of about 4 years might be arranged

If you wanted to finance a holiday trip, you might use a credit card (effectively a short term loan)

Overdrafts do not have a fixed repayment schedule and banks regard them as relatively risky. They usually have relatively high interest rates, but they can be repaid whenever the lender wants to so that gives the lender flexibility. The bank can demand immediate repayment – which can be somewhat precarious for the borrower. Overdrafts are very suitable for short term, temporary needs such as dealing with seasonal stock increases that need temporary funding. They are not advised for long-term financing.

Long term capital will be used to fund assets such as premises and machinery.

Medium term finance is suitable for office equipment and motor vehicles.

Loans can be:

• Fixed rate interest; or
  

• Variable rate interest
  

The former gives certainty about payments but the company loses out if interest rates fall.

Loans can be:

• Unsecured
  

• Secured
  

A secured loan means that the lender has the right to seize a specific asset or assets of the borrower if the loan repayment terms are breached. For example, a loan might be secured on the company’s office building (the building is said to be ‘charged’). If the company defaults on repayments, the lender can ‘seize’ the building and sell it to recover amounts owing.

A fixed charge relates to a specific asset of the company that can be seized and sold.

A floating charge relates to all the assets of the company at the time the charge is exercised.

8 Investing surplus funds

Before deciding what to do with a surplus or a deficit it is worth asking how it arose, because the answer decides how long it will last and therefore what to do about it.

A surplus usually comes from one of four things: trading profitably and collecting the cash faster than it is spent; a seasonal peak, where a business that sells heavily in one part of the year is flush for a few months and short for the rest; a one-off receipt such as selling a non-current asset, a share issue or a new loan drawn down before the money is needed; or simply a lull between capital projects. A surplus that is seasonal or awaiting a known payment is temporary and should be kept liquid; a surplus that keeps building up month after month is permanent, and the question then is whether to invest it in the business or return it to the owners.

A deficit comes from the mirror images: trading at a loss; a seasonal trough; the timing of a large payment such as tax, a dividend or a machine; customers paying more slowly than the business pays its suppliers; and — the one that catches good businesses out — overtrading, where sales are growing so fast that inventory and receivables swallow cash quicker than profits generate it. A growing, profitable business can run out of money, which is why a deficit must never be read as evidence of a loss.

Match the finance to the cause. A short, predictable deficit is an overdraft. A deficit that runs for years is not, and should be funded with a term loan or more capital, because an overdraft is repayable on demand.

It is important that surplus funds do not simply stay in a bank deposit account earning nothing. There are three reasons for having cash available:

• Transactions motive:   the cash needed for day-to-day operations and the purchase of new equipment.
  

• Precautionary motive:   the cash needed to see the business through emergencies
  

• The speculative motive:   cash needed in case a good opportunity arises eg the take over of another company.
  

The cash flow budget looks primarily at analysing the transactions need for cash. However, the company should have cash (or cash available) to cover the other reasons. It might have amounts on deposit in case of need, or it might have lines of credit set up (ie a pre-agreed right to borrow).

This is similar to our private lives: your current account will hold the money for day-to-day living. However, you might like to have some cash in a deposit account in case of a financial emergency. Additionally, you might have a credit card with a relatively high, but unused, borrowing limit. So, if the engine on your car suddenly blows up you have the precautionary motive resources to fix it by dipping into savings or charging it to your credit card.

The cash flow budget will be able to when surplus funds might arise and for how long. These can then be invested in a number of ways:

• Bank deposits.     Many bank deposit accounts are linked to current accounts allowing the instant transfer from one to the other. Some deposit accounts have terms associated with them (for example, the bank must be given 1 month’s notice for repayment, or the minimum deposit length must be 3 months)
  

• Money-market deposits.   These are either fixed term or with a given notice period. They are used for larger amounts, typically over $50,000.
  

• Certificates of deposits.   CDs are documents showing that an amount of money has been deposited with a bank for a given period (typically 6 months). The key feature of a CD is that it can be bought and sold. Whoever owns it at the end of the borrowing term is repaid the money. This means that CDs are ‘liquid’. So, if a company deposits $50,000 with a bank for 6 months and receives a CD to that effect, but needs the money after 2 months, the CD can be sold to realise the investment.

• Government stock (gilts).   These are very safe insofar as almost certainly the interest will be repaid and they will be repaid upon maturity. However, their value can fluctuate as will be demonstrated below. They can be for between 1 and, say 50 years (though some are undated and never repaid). They can be bought and sold very readily on the stock exchange. Their value fluctuates with market interest rates. For example, look at this government stock:
  

Government stocks. These are loans to the government, bought and sold on the stock market. Take a holding of $20 nominal of 5¼% Treasury Stock 20X9. The $20 is the par or nominal value, 5¼% is the coupon rate, and 20X9 is the redemption date — the year the government repays the $20.

  Whoever owns this stock will receive $20 x 5 ¼ % = $1.05 interest every year.

If market interest rates fell to 3%, the owner of the stock would still receive $1.05. If the stock were to be sold, the new owner would receive $1.05. If the bond still cost that person $20 then they would be getting a very high rate of interest (5 ¼ %) compared to the market rate of interest. Therefore, the value of the bond increases until it effectively pays 3%.

  3 = 100 x $1.05/market value

  Market value = $1.05/0.03 = $35

  [Check 1.05/35 = 3%]

• Local authority stocks.   To all intents and purposes these have identical characteristics to central government stocks. There will be slightly more risk as it is more likely that a local authority will default than a country will default.
  

The effect of economic trends on cash management

The right thing to do with a cash balance depends on what is happening in the wider economy, and a question can ask you to say how a trend would change your behaviour.

• Interest rates rising. Holding cash becomes more rewarding and borrowing more expensive. Deposit for short periods so that maturing funds can be reinvested at the new higher rates, avoid locking money away long term, and fix the rate on borrowing rather than leaving it variable. Remember too that the market value of existing fixed-rate government stock falls when rates rise.
  

• Interest rates falling. The opposite. Lock deposits in for longer at today's rates, and borrow at a variable rate so the cost falls with the market.
  

• Inflation rising. Cash loses purchasing power while it sits, and the real return on a deposit may be negative. Hold less idle cash, buy ahead of price rises where storage allows, and review selling prices and credit terms more often, since giving a customer 60 days' credit costs more when prices are moving quickly.
  

• Recession. Customers pay later and some do not pay at all, so collections slow and bad debts rise. Hold a larger precautionary balance, tighten credit control, and be cautious about long-term commitments of cash.
  

• Credit conditions tightening. Banks become slower to grant and quicker to withdraw facilities. Arrange and confirm borrowing facilities before they are needed, and do not rely on an overdraft that is repayable on demand.
  

• Exchange rate movement. A business that receives or pays in a foreign currency finds the domestic value of those flows changing, which affects both the forecast and the decision about which currency to hold balances in.
  

9 Interest rate calculations

Interest rate calculations apply to both borrowing and lending. You have to be aware of the meanings of the following terms.

Simple interest

Interest is always calculated with respect to the original amounts deposited (the principal).

Compound interest

Interest is always calculated on both the principal and the interest earned so far.

The general formula is:

Final amount invested = Principal x (1 + r)ⁿ

where:   r = interest rate as a decimal;

    n = number of years.

Nominal interest rates

The word ‘nominal’ means ‘not real’. So the nominal head of a country is a figurehead and not where the real power lies. Similarly, ‘nominal interest rate’ means that the figure is not the real interest rate. The discrepancy arises because although interest is often paid several times a year (for example monthly), the interest rate is expressed in annual, nominal terms.

To work out the interest that will actually be charged or earned it is necessary to work out the effective annual interest rate.

The effective interest rate is given by:

Effective interest rate = (1 + r)^12/n – 1

where:   r = rate of interest for each time period

    n = number of months in the period

In the example above,

Effective interest rate = (1 + 0.0225)^12/3 – 1 = 0.0931 or 9.31%

After a year, if $1,000 had been placed on deposit, there would be $1,093.10 in the account.

10 Types of payment from the bank

Payments can be made from a bank account in four main ways:

• Cheques:     see later
  

• Internet transfer:   now very common. It is vitally important that account log-on details are kept secure. In addition to user-known passwords, some banks now issue devices that generate unique use-once codes. Access to the bank account is then possible only by someone who both knows the password and who possesses the device.
  

• Direct debit.     Here the person receiving the funds has the right to extract them from the bank account. This is often used by institutions like insurance companies to collect insurance premiums from clients. The process can be completely automated.
  

• Standing order     Here the person paying instructs their bank to pay a regular amount to the recipient. This is often used to pay regular amounts like rent. The process can be completely automated.
  

All payments should be properly authorised and approved.

In addition, banks can remove funds from accounts for interest and bank charges.

11 Cheques and the clearing system

Cheques are unconditional orders in writing given to a bank (the drawee) by the person paying out of his or her bank account (the drawer of the cheque) to pay an amount to the payee (the person receiving the money).

Cheques are now a small and shrinking part of business payments, but the controls around them still get examined. Blank cheque books must be locked away, because a signature can be forged. Cheques should be signed only against a supporting invoice, and large amounts should need two signatures. A spoiled cheque is not thrown away: it is marked “cancelled” and kept, so that every cheque number can be accounted for.

A cheque received should be banked the same day. Until it is, the money is not earning anything and the cheque can be lost or stolen. It is entered on a paying-in slip, and the amount appears in the account as soon as it is paid in — but only provisionally, because the paying bank can still return it unpaid if there are not enough funds, in which case the amount is taken back out of the account.

Clearing a cheque now takes about one working day in most countries, because the cheque is imaged and the image is exchanged electronically rather than the paper being carried between banks. An electronic transfer is faster still: many bank transfers clear in seconds and almost all within the same day. That speed is one of the main reasons businesses have moved away from cheques towards direct debits, standing orders and electronic transfers, which are also cheaper to process and far easier to control because they are authorised once and then applied automatically.

12 Cash flow forecasting

Cash flow forecasting can be complicated by:

• Inflation
  

• Seasonal fluctuations and trends in operations.
  

Inflation and index numbers

Price inflation is typically measured by an index, in general calculated as:

The base year is an arbitrary date from which price rises are measured.

The index is usually expressed as points (Which are essentially which start at a value of 100.

So:

If the price in 2015 is $54, then in 2015 the index will be $54/$45 = 120.

This means that the price has risen 20% from the base year.

Although individual commodities can have an index calculated as above, often companies (and certainly individuals) are buying a collection, or basket, of items and economies are therefore subject to general inflation based on the mix of items bought. From time to time the mix of goods in the ‘basket’ is changed to keep it up to date. For example, 25 years ago or so, mobile phone costs would not have been very important to most people, but now they are material and should be taken into account.

Most countries publish such an index of general consumer prices, compiled by the national statistics office, and it is the usual starting point when a business needs an inflation assumption for a forecast, a wage negotiation or a price adjustment clause in a contract. Some countries publish more than one, measured on slightly different baskets, so a contract should always name the index it means. For cash forecasting, what matters is not which index is chosen but that the same one is used consistently.

Seasonal fluctuations and trends in operations

If you were to plot, say sales, against time, it is common to find a pattern such as:

Clearly there is an underlying increase in sales but that there are also regular variations.

• The underlying increase is called the trend
  

• The regular variations repeating in less than a year are called seasonal variations
  

So, a holiday company’s sales are generally increasing but superimposed on that increase are busy periods (such as summer) and slack periods (such as winter)

It is very important to take the seasonal variations into account when working out cash flows. Although over a year the company might be cash positive, it might have several months where it is cash negative and it has to have enough cash available to cover the hard times before business picks up again.

There are two other types of variation which are not used in predictions:

• Random   (such as the effect of a strike on revenues). By definition these cannot be predicted but some precautionary cash should be available to handle disappointments.
  

• Cyclical.   These are regular but with a very long repeat period. For example the economic cycle seems to go in a cycle length of about 12 years.
  

The trend and seasonal variations over time are estimated using the technique of moving averages

Look at this series of sales results. The raw results are listed in column 3, and you will see that the sales figures follow a reasonably regular pattern. For example in all of the first quarter’s sales seem to be particularly high, and in all of the second quarters seem to be particularly low.

To smooth these out averages of each set of four quarters are calculated (the 4-part moving average). So

1350 = (2,000 + 900 + 1,000 + 1,500)/4

1,400 = (900 + 1,000 + 1,500 + 2,200)/4

ie, for the calculation, move down one quarter at a time.

These averages are not ‘opposite’ any season, so the process is repeated to obtain the 8-part centred moving average: 1,375 = (1,350 + 1,400)/2; 1,413 = (1,400 + 1,425)/2 etc.

This is the trend, and you will see that these figures rise constantly and that the seasonal variations have been smoothed out. The increase per quarter can be calculated by saying that sales have increased by 351 (from 1,375 to 1,726) in 7 increments (there are 8 trend figures and 7 increases). The trend per quarter is therefore 351/7 = 50

Seasonal variations

The seasonal variations are the differences between the initial sales figure and the trend figures (additive model) or the ratio of actual sales compared to trend (multiplicative model). These can be collected together and averaged:

Seasonal variations additive model:

Seasonal variations multiplicative model:

Predictions

These results can now be used for predictions. For example, the sales figure for season 3, year 4 would be predicted by;

Trend: This season is 5 seasons further on (count from Yr 3 season 2, the last trend figure, to 3.3, 3.4, 4.1, 4.2, 4.3) so the trend figure will be;

  1,726 + 5 x 50 = 1,976

Then adjust for the season 3 seasonal effect using the additive adjustment (- 350) or the multiplicative adjustment, and the predictions will be:

  1,976 – 350 = 1,626

or

  1,976 x 0.76 = 1,502

You should not expect the additive and multiplicative models to give the same estimates of future sales.