Cash management

Tips on cash management By ELIJAH Presented on the CEOs HUB Kenya group, 7th of April 7, 2016 “I will be taking us through some tips on cash management now that it's a great concern.. Cash is the most liquid of assets and it represents the lifeblood for growth and investment. In order to generate cash, we must efficiently and effectively manage the activities that provide cash. These activities include billing customers as quickly as possible, disbursing payments only when they come due, collecting cash on overdue accounts, and investing idle cash. Therefore, managing cash flow involves several objectives: √Accelerating cash inflows wherever possible. √Delaying cash outflows until they come due. Investing surplus cash to earn a rate of return. √Borrowing cash at the best possible terms. √Maintaining an optimal level of cash that is neither excessive nor deficient. We will attempt to outline how these objectives can be met by trying to answer the following questions: *How much cash do we need to run our business? *How much cash is locked-up in other current assets? *How long does it take to collect our cash from customers? *How much cash should we hold? *How do we cover cash deficits? *How do we identify problems with cash flow? The 2nd cycle is.. Receipt Cycle: The total time between when products or services are delivered and when payment from the customer clears the bank. Lesson 2. Cash flow management consists of several activities: Collecting accounts receivable, processing vendor payments, etc. We need to understand the time involved with each of these activities before we can properly plan our cash flows. Since cash consists of disbursements and receipts, we can think of cash flow in terms of two cycles. Disbursement Cycle: The total time between when an obligation occurs and when the payment clears the bank. The overall objective within the Disbursement Cycle is to increase the cycle time; i.e. delay making payments until they are due. We can delay payments by: >Mailing checks from locations not close to customers. This will increase the mail time or mail float within the disbursement cycle. >Disbursing checks from a remote bank. This will increase the time required for the payment to clear the bank; i.e. clearance float. >Purchasing with credit cards so that the time required for making payment is much longer. By using a credit card, you will receive a bill at the end of the month payable in 30 days. This creates more processing time or processing float. Therefore, when we manage cash flow cycles, we try to control three types of float times: •Mail Float: Time spent in the mail. •Clearance Float: Time spent trying to clear the bank. •Processing Float: Time required to process cash flow transactions. NB. By increasing the float times within disbursements, we have the use of cash for several more days. This is a source of spontaneous financing and we can measure our cash savings. The overall objective within the Receipts Cycle is to decrease the cycle; i.e. shorten the time necessary to collect and have use of cash. We can shorten the receipt cycle by: √Invoicing customers as quickly as possible. √Taking immediate action when a customer becomes delinquent. √Rewarding customers for making early payment by offering a discount. √Imposing a finance charge on customers that are seriously delinquent. √Evaluating the financial soundness of customers before extending credit. √Accepting credit cards for payment. √Issuing monthly statements to remind customers of amounts owed. √Placing collection centers near customers and/or having banks control deposits. **** You may also adopt : A lockbox system is an example of placing control with the bank. Under a lockbox system, customers send payments to a lockbox which is cleared daily by the bank. This can reduce processing time for deposits and reduce clearance float. Before adopting a lockbox system, you should weigh the costs versus the benefits MONITORING CASH FLOWS. Measuring Cycle Times In order to monitor progress in managing cash, it is useful to understand how much cash is locked-up; i.e. not available to us. We can get an idea of cycle times by looking at average days in inventory, average days in receivables, and average days in payables. These three components cover the two basic cash flow cycles, disbursements and receipts. a: Average Days in Inventory = Average Inventory Balance / Average Daily Cost of Goods Sold b: Average Days in Receivables = Average Receivable Balance / Average Daily Credit Sales c: Average Days in Payables = Average Payables Balance / Average Daily Purchases on Account The overall cash flow cycle time is calculated as: a + b - c; i.e. inventory and receivables tie up cash receipts less payables for disbursements Lesson 3. Failure to PLAN,is PLANING to fail, this brings us to next very important aspect of managing cash,ie PLANING. Cash Flow Planning One of the objectives of cash flow management is to hold the right amount of cash. If we hold too much cash, we lose the opportunity to earn a return on idle cash. If we hold too little cash, we run the risk of not making timely payments to suppliers, banks, and other parties. We want to have an optimal cash balance that is neither excessive nor deficient. The optimal cash balance is determined by looking at the four reasons for holding cash: =Transaction Amounts: We have to hold enough cash to cover our outstanding payments or transactions. In addition to transaction amounts, we should add any compensating balances required under loan agreements. Therefore, the amount of cash on hand must be transaction amounts + compensating balances. =Precautionary Amounts: We need to maintain cash for unexpected disbursements. This is the precautionary amount of cash. =Speculative Amounts: If we are anticipating making an investment, we will hold a speculative amount to take advantage of opportunities in the marketplace. =Financial Amounts: In order to acquire assets, retire debt, or meet some major event, we will accumulate and hold a financial amount of cash. NB. Key Point (The minimal cash balance is usually equal to the total transaction amount (includes compensating balances) + total precautionary amount. #Cash Flow Forecasting One of the best ways to determine the optimal cash balance is to fully understand cash flow patterns. This requires that we plot cash flows and prepare a forecast. A cash flow forecast gives us a detail projection of future cash inflows and outflows. This will help us avoid cash deficiencies as well as excessive cash balances. A cash flow forecast also answers several questions, such as how long can we invest idle cash, when will it be necessary to borrow cash, and when can we purchase new capital assets? A typical cash flow forecast will include: Cash on Hand, Expected Receipts, and Expected Disbursements. Each major receipt and disbursement should be listed as a separate line item. Finally, consider the following points when preparing cash flow forecasts: 1.Prepare cash forecasts for shorter periods of time (weekly or daily) if cash flows are tight. 2.Use available data as much as possible to prepare cash flow forecasts. 3.If necessary, prepare two forecasts: Early 4.Warning Forecast for longer periods of time (six months) and Targeted Forecast for shorter periods of time (weekly). 5.Be advised that cash flow forecasting is extremely difficult in periods of rapid growth. 6.Special Bank Accounts NB. One method for maintaining an optimal cash balance is to use Zero Balance Accounts, Sweep Accounts, and Investment Accounts. These accounts will automatically invest surplus cash while still serving as your main transaction account. Disbursements are cleared through a special account which has just enough cash to cover all transactions. The Bank makes a "sweep" of the account and takes any surplus cash and places it into a money market account. Money market accounts are one of the most popular accounts for investing surplus cash. Brokerage houses also offer investment accounts which sometimes earn slightly higher rates than money market accounts. When deciding which types of accounts to use, consider the following guidelines: >If your average daily surplus cash exceeds $ 500,000, setup a direct overnight investment program with a brokerage house. >If your average daily surplus cash exceeds $ 50,000, but is well below $ 500,000, setup a sweep account with your bank. >If your average daily surplus cash is below $ 50,000, consider using a regular investment account with a brokerage house. Note. The above figures are estimates.. The overall collection process should be pro-active and preventative. For example, wherever possible try to collect payment immediately as products or services are delivered. This eliminates the need for invoicing and follow-up collection. Require deposits from customers that have a history of late payments. Use credit applications to weed-out bad customers. Include a clause in the credit application that states all collection costs are reimbursed by the customer on delinquent accounts. Finally, if you receive payment in the form of a bad check, retain the check as evidence that you have a valid claim. Disbursement Practices How you manage various disbursements and current assets can have a big impact on cash flows. There are several problem areas to watch-out for, such as payroll, purchasing, inventories, and insurance. Payroll: Payroll is a large cash outflow and requires special attention. One obvious trend in payroll is to implement a flexible workforce since the flow of work fluctuates. Outsourcing and temporary workers are often part of a flexible workforce. Retain a full-time workforce for core activities. You can also increase payroll float times by simply distributing payroll checks after 2:00 p.m. Banks will not clear payroll checks until the following week. Purchasing: Flexible purchasing can help cash flow. Consider renting certain items as opposed to purchasing. Ask yourself do we really need this item and how often will we use it? If practical, order items out-of-season when prices are low. Finally, consider using credit cards to make purchases since this will give you more time for making payment. Inventory: Inventories have several hidden costs that can drain cash flow. These costs include storage, insurance, spoilage, handling, taxes, and financing. Get rid of inventory that is not moving. Obsolete inventory should be removed immediately. Find new ways of disposing of inventory. For example, it is better to sell inventory at costs than not at all. Your overall objective is to maintain inventory levels at a profitable level. Insurance: Make sure you do not over insure your business. Purchase insurance in group packages to obtain the lowest premiums. Start by covering your largest risks first. Structure as high a deductible as you can afford. Avoid duplication and excessive insurance. Shift certain costs, such as health insurance to the employee through higher payroll deductions. Insurance should be used to cover risks that are material, but occur infrequently. Warning Signs One important element in cash flow management is to fully understand the warning signs of cash flow distress. Some early warning signs include: Cash balances are low compared to historical balances. Inventory is not moving. Vendor payments are made late. Banks are requesting financial statements. Major purchases have to be postponed. Management has become very risk adverse; i.e. overly cautious about spending money. One way to monitor cash flow is to track liquidity ratios and compare these ratios to historical ratios and/or industry averages. Some examples include: Current Ratio = Current Assets / Current Liabilities Acid Test = Cash + Accounts Receivable + Marketable Securities / Current Liabilities Cash Flow to Debt Ratio = Cash Flow / Total Debt Cash Flow to Income Ratio = Operating Cash Flow / Net Income Another warning sign is an unfavorable Z Score. The Z Score is about 90% accurate in predicting bankruptcy in the first year and about 80% accurate the second year. The Z Score combines five ratios and compares the result to a scoring scale. A weight is assigned to each ratio. The Z Score is calculated as follows: Z = 1.2 (A) + 1.4 (B) + 3.3 (C) + .6 (D) + .999 (E) A: working capital / total assets B: retained earnings / total assets C: earnings before interest taxes / total assets D: market value of equities / book value of debt E: sales / total assets The scoring scale for the Z Score is: If the Z Score is 1.8 or less, there is a very high probability of bankruptcy. If the Z Score is 1.81 to 2.99, we are not sure about bankruptcy. If the Z Score is 3.0 or higher, bankruptcy is unlikely. In addition to bank financing, you can borrow against your assets from a financing company. Accounts Receivable is a liquid asset that provides a form of financing. In order to borrow against your accounts receivable, you must meet the following criteria: Receivables are related to the sale of merchandise and not services. Receivable customers are financially sound and there is a high probability of payment. Receivable customers obtain title to merchandise when it is shipped. Your overall receivable balance is at least $ 50,000 with sales that are substantially higher than your receivable balance. There are two forms of receivable financing, factoring and assignments. 1.Factoring: Under this form of financing, you sell your receivables to the financing company. You receive the face value of the receivable less a commission charge. The financing company assumes responsibility for collecting the receivable. Factoring gives you immediate cash and freedom from collecting from customers. However, it is costly and it sometimes confuses customers since they now make payment to a financing company. 2.Assignment: Under this arrangement, you transfer or assign your receivables over to the financing company. However, you still retain ownership of the receivables. The financing company advances 60% to 80% of the receivable balance. You continue to collect the receivables and the financing company charges you interest and service fees on the borrowed funds. Inventory Financing: Inventory financing is similar to receivable financing. Inventory financing has the following requirements: Inventory must be highly marketable. Inventory is non-perishable and not subject to obsolescence. Inventory prices are relatively stable. There are three forms of inventory financing: *Floating or Blanket Liens: The financing company will place a lien on your inventory; i.e. they obtain a security interest in your inventory in exchange for lending you cash. You continue to manage and control the inventory. Warehouse Receipts: The financing company obtains an interest in a certain segment or part of your inventory. You will have to separate the inventory that you use for financing from the inventory not used for financing. This may require physical separation as well as separate accounting. *Trust Receipts: The financing company lends you money for a specific item in your inventory until you are able to sell it. When you receive cash for the inventory sale, you pay the financing company. For example, car dealerships often buy automobiles by financing the purchase. When the car is sold, they payoff the financing company. Lesson 4 SHORT TERM FINANCING. Part of managing cash flows is to understand how to finance operating cash flows. We previously discussed how to predict cash deficits with forecasting. We now have to understand how to finance our cash flow deficits. Whenever we use short-term financing to cover cash deficits, we must consider costs, risks, restrictions imposed upon the organization, financing flexibility, our current financial situation, and other factors. Some of the questions we need to ask include: *How long will we need financing? *How much cash do we need? *How will we use the borrowed funds? *When and how will we repay the borrowed funds? The first and most practical source of financing is spontaneous financing or trade credit. By lengthening the disbursement cycle, we obtain additional cash. Once we have exhausted spontaneous sources of financing, we than use conventional sources of financing, such as bank loans, lines of credit, and asset based borrowing. Bank Financing One of your key partners in business should be your bank. Therefore, it is essential that you establish a good working relationship with a bank officer. This relationship is the basis for how you will obtain bank financing. For example, a line of credit is one way to address recurring cash deficits. You can also arrange a revolving loan. Under these arrangements, you borrow as deficits occur up to a maximum amount. Unless you have excellent credit, you will be required to put up collateral (such as receivables, inventory, etc.). The bank may also require a commitment fee or compensating balance (percentage of loan). Some key points about bank financing are: √Make arrangements to borrow when you least need it. This is the best way to obtain favorable terms and conditions for short-term financing. √Borrow more than you think you will need. Many organizations under-estimate the amount of borrowing required for short-term financing. √The moment you think you will need short term financing, begin preparing immediately. √Bank financing takes time to arrange and execute. √Borrow to meet your strategic plans, not to avoid possible bankruptcy. Banks are much more receptive to financing when it fits with some type of long-term plan. √Make sure you maintain the best possible relationship with the bank. Send regular reports and information to the bank officer. Summary Managing cash flow is a major balancing act between making sure all obligations are paid on time, doing everything you can to collect cash as quickly as possible, and not holding excessive cash balances. An understanding of cash flow cycles is an important first step in managing cash flows. Once you understand the cycles, you want to lengthen the disbursement cycle and shorten the receipt cycle. Controlling float times is a common way of adjusting cash flow cycle times. In order to understand the magnitude and timing of cash flows, you need to plot cash flows. This leads to the use of cash flow forecasts. Cash flow forecasts help optimize the amount of cash that should be held. Cash flow forecasts also help identify when short-term financing will be required. Finally, be aware that cash flows are influenced by many factors, ranging from payroll to inventories. A static workforce and runaway inventories can be detrimental to cash flows. You need to be aware of the warning signs of cash flow distress, such as late vendor payments and delayed purchases. Finally,I'll share one of my favourite quotes bout money..hope u will like it too.. “Dogs have no money. Isn’t that amazing? They’re broke their entire lives. But they get through. You know why dogs have no money? .. No Pockets.” – Jerry Seinfeld Thank you so much for your time, in case of any questions, I can answer them in the evening. Good afternoon..” Yours ELIJAH, ENTREPRENEUR, FINANCIAL ANALYSIS STUDENT.te