Cash is the lifeblood of any business. Imagining a day without cash is no less than a nightmare. Imagine a business running out of cash; it will be no less than a disaster. For any business entity, cash is the primary source of meeting day-to-day cash needs. Cash is also employed by a business for the purchase of capital investment, including property, plant, and equipment.

The cash flow statement is a financial statement of a business entity to track the cash inflows and outflows. In other words, it is one of the main cash management and tracking tool. The cash flow statement records all the operating activities that include inflow or outflow of cash, financing activities, and investing activities involving cash.

Chief financial officers, treasurers, cash officers, and business managers are primarily responsible for comprehensively recording and tracking the organization’s cash inflows and outflows. Some business entities choose to outsource the cash management function instead of doing it in-house.

This article will discuss cash management in any business entity, different models, strategies, and limitations in cash management systems. So let’s get into it.

What is cash management?

Cash management is basically the management of a business entity’s cash inflows and outflows. However, we can formally define cash management as,

It is the set of activities related to cash inflows and outflows. It includes collection, payment, handling, controlling, recording, and tracking different events and transactions that involve cash. Cash management is done to optimize the utilization of money by a business, as cash is the most critical resource of a business entity.

The most common areas of a company’s operations where cash management is extensively used include account receivables and account payables.

Role of cash management

Cash management plays a pivotal role in the short-term financial stability of a business. The working capital of a business entity is represented by the net cash held by a company. Secondly, cash management allows the management of the wealth portfolio of the business.

Cash management is often known as treasury management in many corporate businesses. The role of cash management activities is to ensure that enough cash is available to the business for meeting its short-term obligations and fund its operations.

Objectives And Function

Cash management practices in any business entity or individual serve multifold objectives.

Working Capital Requirement

Working capital is ‘the difference of current assets and current liabilities.’ If a company’s current liabilities are lower, then the working capital will not be enough. Similarly, if working capital is in excess, it is also unhealthy for business. Therefore, cash management practices are adopted to ensure that enough working capital is available for the company by balancing receivables and payables.

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Capital Expenditure Planning

The cash flow statement of a company encompasses investing activities and financing activities besides the operational activities. Therefore, cash management is also focused on capital expenditure planning. When a business entity wants to make any capital expenditure, cash management calculates debt to equity ratios for financing activities.

Unorganized Costs Handling

Life is not certain so are not the expenses. Your machinery may run out unexpectedly, or another unforeseen expense might require your attention. By optimal cash management, business entities are able to keep cash surplus to meet the contingencies, and unexpected cost spreads.

Source Of Investment

If the capital budgeting process and analysis have shown that an opportunity is worth investing money in, where do the finances come from? The financial managers of companies decide to initiate an investment providing the right exposure to the business by optimal cash management practices.

Optimization Of Resources Utilization

Cash management divides all the cash & money-related transactions into operating, financing, and investing activities. From thereon, the business managers can predict the patterns of cash expenditure for different activities and how much cash is needed for operational activities. As a result, the company is better equipped with information to optimize the use of its resources by investing in fruitful opportunities.

A Good Measure Of solvency

Keeping too low or too high cash is not beneficial for the company’s health. Even low cash can make the nightmare of insolvency come true. If there is a balance created by the cash management practices, it allows the company to plan ahead for avoiding insolvency in the future.

Models

The most popular methods for cash management are Baumol’s model and Miller-Orr’s Model. However, another model used by entities is the Stone model. Let’s talk about each model and how it helps businesses manage their cash activities.

Baumol Model

The Baumol model was proposed by William Baumol in 1952. It is also called the Baumol-Allais-Tobin model. According to the Baumol model, cash management is similar to inventory levels. Therefore, Baumol developed a model for cash management that is very similar to the inventory model of economic Order Quantity(EOQ).

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The formula for the Baumol model is as follow:

Where,

C*= It is the optimal level of cash that a company need to have for reaching the working capital requirement

F= it is the cost of acquiring the cash C*. The F includes carrying costs and transaction costs. The costs of cash are calculated by summing up the transaction and holding costs.

T= what did the company spent during the time interval

r = it is the interest rate during the time interval T

The Baumol model is extensively used by different business entities. However, one limitation is that it does not consider the inflows and outflows and only considers net cash outflow.

Miller-Orr’s Model

Miller-Orr’s model was proposed in 1966, and it is based on the proposition that cash flow is stochastic. It means that different cash amounts are paid at different times. The Millers-Orr model signifies random payments of cash within a business entity.

The cash management model emphasizes that any amount of cash inflows and outflows should result in a predetermined balance of normal points. If the outer or inner limits of cash are exploited by a transaction, it should be adjusted back.

Management chooses the lower limit whereas, the upper limits are calculated by the formula. The working of Miller-Orr model goes in the following way:

  • The cash movement should remain within the upper and lower limit and most favorably at the normal point. When the cash balance increases and touches the upper limit, market securities are bought to reach the new balance. The amount spent for buying securities is a difference of the upper limit and the cash balance.
  • When the cash balance reaches a lower limit point, the management sells securities to raise cash levels to the normal point.
  • The new cash balance in both scenarios is represented by z.

h = upper limit representing the maximum point to the extent a company can hold cash

o =lower limit representing minimum cash requirement that a company should hold at a given point in time

z = normal balance or return point for cash

The Miller-Orr model works on the basic assumption that cash movements do not work on defined patterns but move randomly.

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Stone Model

It is also a cash management model that might not be as popular as the other two. The stone model works similarly to the Miller-Orr model in terms of limits. However, unlike the previous model, the stone model works on forecasting cash flows when hitting upper or lower limits occurs. Instead of adding or drawing cash, it is analyzed if the cash corrects itself in the coming days. For instance, the cash might be hitting a lower limit at a given time. However, there is the expectation of cash inflow for the accounts receivables in 3 days. So, the model works on forecasting whenever cash limits reach.

Strategies For Cash Management

Besides following different cash management models, business entities should strategize their methods and practices for managing cash effectively. Therefore, some good habits and cash management strategies can be as follows:

  • Cash planning and budgeting will allow the company to prepare for its expected cash flows and inflows in future financial periods
  • Offering Discounts To Encourage Debtors will reduce the bad debts and encourage debtors to clear their accounts earlier.
  • A cash Collection Policy should be devised and implemented to streamline cash receivables. A business entity can also use automation tools and software to automate the process of invoicing, sending reminders, and monitoring cash collection.

Limitations

Cash management is a very effective practice, and it can save a business entity from facing difficult cash shortages or idle cash situations. However, there are some shortcomings of the practices that obviously do not overcome the benefits.

Following are some of the limitations cash management has:

  • Many small businesses that follow cash management do not take into consideration the accrual concept of accounting.
  • You cannot and should not use cash management as a replacement for the profit and loss statement. Many small businesses and sole proprietors are just considering cash inflows and outflows irrespective of profit.
  • Non-cash transactions are completely ignored, which is a violation of the matching principle of the GAAP.

Conclusion

Treasury management or cash management solves most of the business problems related to dealing with cash. Business entities must employ different strategies and methods to ensure optimal cash management in their enterprises.