Managing Business Cash Effectively - dummies

Managing Business Cash Effectively

Effective cash management is at the heart of every business. The phrase ‘cash is king’ is as true today as it was hundreds of years ago. Companies can make boat-loads of profits, but unless those profits are cash-backed, they’re essentially just numbers on bits of paper.

Companies want to optimise the cash they have and maximise the interest they earn on surplus funds. Companies that hold on to spare cash to meet short-term requirements face an opportunity cost, which is the return that they would have received if the cash had been invested or put to productive use. In corporate finance, companies usually have three motives for keeping their hands on cash:

  • Transactions motive: Refers to a company that needs to keep hold of a cash reserve to meet the gap between cash coming in and cash needing to go out. Companies use cash flow forecasts and budgets in attempts to work out the size of the cash reserve they need to meet day-to-day operational expenditure or where one-off cash outflows are anticipated, such as the maturity of a loan.

  • Precautionary motive: Refers to an uncertain demand for cash. An example is where a company is waiting on the result of a lawsuit and uncertainty exists as to whether they’ll have to pay damages and costs to the claimant. In this case, the company may hold a certain amount of cash in case it has to pay such damages and costs.

  • Speculative motive: Refers to where a company builds up a reserve of cash in order to take advantage of any investment opportunities that may arise. If such opportunities don’t present themselves, the company should return the cash to shareholders; for example, by way of an additional dividend.

Optimum cash levels vary from company to company. The key to effective treasury management is always to maximise interest earned on spare cash but reduce losses caused by delays in transmitting funds; sometimes company managers need to perform a fine balancing act between the two.