Cash management definition
/What is Cash Management?
Cash management involves the oversight of every cash inflow and outflow that a business experiences, with the goals of always having enough liquidity to operate the business, and finding the best possible use for any remaining liquidity. The key aspects of cash management are noted below.
Aggregation of Cash Information
It is impossible to manage cash without knowing where it is, when more is expected, and how soon it will be used. This knowledge requires an excellent information aggregation system that reveals where the company is currently storing cash, and the nature of its short-term receivables and payables. This is usually part of a treasury management system.
Liquidity Management
With an adequate knowledge of cash flows in hand, it is then possible to invest excess funds or acquire debt in an orderly manner, so that sufficient cash is always on hand to meet the operational needs of the business. Again, liquidity management can be run with a treasury management system.
Risk Management
A company’s business partners should be regularly evaluated to see if their financial circumstances could lead to failure, which may call for changes in credit policy; this examination can extend to entire groups of partners or geographic regions. Further, the company’s foreign exchange holdings should be continually reviewed to see if any hedging transactions should be enacted to offset the risk of currency fluctuations. The same methodology can be applied to fluctuations in interest rates.
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The preceding list of cash management aspects were listed in order of importance, for liquidity and risk management are impossible without a system for aggregating cash flow information. Also, improper or nonexistent liquidity management will bring a company’s operations to a halt in short order, so that must take priority over risk management. Despite its last place positioning on the list, risk management is still important, since a company can incur massive losses if it does not pay attention to the risks posed by counterparty failure or fluctuations in currency exchange rates.
Responsibility for Cash Management
Cash management is typically assigned to the treasury department. There may not be a person within that department with the “cash manager” title; instead, the treasurer has overall responsibility for cash management, and he or she parcels out cash management tasks among the treasury staff. The key cash manager tasks that should be handled by the treasury department are:
Forecast cash. It is impossible to manage cash without having a detailed cash forecast in place that is updated regularly. This forecast should incorporate a timeline sufficiently long to encompass the longest-term investment strategy that the treasurer plans to use. A cash forecast is the source document for many treasury functions.
Systems analysis. A cash forecast cannot be constructed unless the underlying accounting systems that record cash-related activities are properly forwarding information to the treasury department in a timely manner. Accordingly, the treasury staff should have an excellent knowledge of how information is collected, aggregated, and forwarded, as well as the areas in which errors are most likely to occur, and which types of information are not included in these formal data collection systems.
Monitor cash flows. The cash manager should monitor cash receipts and disbursements continually, and shift funds among the company’s various bank accounts and investments in reaction to those cash flows.
Ensure liquidity. The key cash management task by far is to ensure that there is always enough cash on hand to support company operations. This means at least having sufficient cash to pay a company’s trade accounts payable and payroll obligations when they are due. Having sufficient liquidity requires that a portion of all cash be invested in readily-liquidated investments, and that a sufficient line of credit is accessible to provide funds for any remaining obligations.
Obtain funding. A key aspect of liquidity is to ensure that a company has access to a sufficient amount of debt financing at a reasonable interest rate. This is usually a mix of long-term debt on a fixed repayment schedule and a short-term line of credit. It may also be necessary to sell company stock from time to time to obtain additional funding.
Manage risk. There should be continual monitoring of the risk posed by the types of investments used, the stability of lenders, legal restrictions on cash flows, and the inherent variability of foreign exchange rates and interest rates. An active treasury staff can alter investments, change lenders, and engage in a variety of passive and active hedges to mitigate these risks.
Invest cash. It is much more important to ensure proper liquidity levels than to obtain a high return on investment. Nonetheless, the cash manager should ensure that all excess cash is “working” for the business by parking it in some form of investment, no matter how small the return may be. The result may be a mix of short-term and long-term investments, or a reduction in the amount of outstanding debt.
Cash Forecasting and Cash Management
The short-term cash forecast is based on a detailed accumulation of information from a variety of sources within the company. The bulk of this information comes from the accounts receivable, accounts payable, and payroll records, though other significant sources are the treasurer (for financing activities), the CFO (for acquisitions information) and even the corporate secretary (for scheduled dividend payments). Since this forecast is based on detailed itemizations of cash inflows and outflows, it is sometimes called the receipts and disbursements method.
The forecast needs to be sufficiently detailed to create an accurate cash forecast, but not so detailed that it requires an inordinate amount of labor to update. Consequently, include a detailed analysis of only the largest receipts and expenditures, and aggregate all other items. The detailed analysis involves the manual prediction of selected cash receipts and expenditures, while the aggregated results are scheduled based on average dates of receipt and payment.
The medium-term cash forecast extends from the end of the short-term forecast through whatever time period the treasurer needs to develop investment and funding strategies. Typically, this means that the medium-term forecast begins one month into the future. The components of the medium-term forecast are largely comprised of formulas, rather than the specific data inputs used for a short-term forecast. For example, if the sales manager were to contribute estimated revenue figures for each forecasting period, then the model could derive the following additional information:
Cash paid for cost of goods sold items. Can be estimated as a percentage of sales, with a time lag based on the average supplier payment terms.
Cash paid for payroll. Sales activity can be used to estimate changes in production headcount, which in turn can be used to derive payroll payments.
Cash receipts from customers. A standard time lag between the billing date and payment date can be incorporated into the estimation of when cash will be received from customers.
A possibly more precise method for deriving cash paid for cost of goods sold items is based on the presence of a constraint somewhere in the company’s production or administrative systems that chokes the flow of orders. If this bottleneck exists, estimate sales based on the capacity of the constraint; at a minimum, do not forecast for cash flows derived from sales that exceed the capability of the constraint, since it is impossible for the system to generate these additional amounts.
The concept of a formula-filled cash forecast that automatically generates cash balance information breaks down in some parts of the forecast. In the following areas, the treasury staff will need to make manual updates to the forecast:
Fixed costs. Some costs are entirely fixed, such as rent, and so will not vary with sales volume. The treasury staff should be aware of any contractually-mandated changes in these costs, and incorporate them into the forecast.
Step costs. If revenues change significantly, the fixed costs just described may have to be altered by substantial amounts. For example, a certain sales level may mandate opening a new production facility. A more common step cost is having to hire an overhead staff position when certain sales levels are reached. The treasury staff should be aware of the activity levels at which these step costs will occur.
Seasonal / infrequent costs. There may be expenditures that only arise at long intervals, such as for the company Christmas party. These amounts are manually added to the forecast.
Contractual items. Both cash inflows and outflows may be linked to contract payments, as may be the case with service contracts. If so, the exact amount and timing of each periodic payment can be transferred from the contract directly into the cash forecast.
The methods used to construct a medium-term cash forecast are inherently less accurate than the much more precise information used to derive a short-term forecast. The problem is that much of the information is derived from the estimated revenue figure, which rapidly declines in accuracy just a few months into the future. Because of this inherent level of inaccuracy, do not extend the forecast over too long a time period. Instead, settle upon a time range that provides useful information for planning purposes. Any additional forecasting beyond that time period will waste staff time to create, and may yield misleading information.
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