Liquidity, Investment and Cash Flow

You may be wondering what theories there could be about cash! We all know what cash is, and the more of it we have the better - or is it?? What we have to remember about cash is that it has an opportunity cost. If a firm holds too much cash in the bank, then that money is not working for it as hard as it could be. So in the same way that too little cash may be a problem, too much also has negative implications.

There are various aspects to the firms cash management:-

• Liquidity
• Investment
• Cash flow

Liquidity

The firm has to ensure that it has sufficient cash for all its day-to-day activities. It needs to be able to pay its bills when they are due and pay its staff and so on. It therefore needs to have sufficient of its cash in a liquid form to cope with all contingencies. However, the more liquid a form the cash is in the less it will be earning for the firm. You could check this by trying to compare the rates that a bank or building society offer for money that is tied up for different time periods.

Investment

This is linked in with the notion of liquidity. If the firm has surplus cash for its day-to-day needs it should perhaps think about investing it. This investment could be a financial one (portfolio investment), or it could perhaps be investment in fixed assets (productive / direct investment). Either of these will make the money work harder than it will in a more liquid form. The firm does, however, need to plan carefully to ensure that it has planned as necessary for its future cash needs. This is where the next bit comes in...................

Cash Flow

Because the firm is constantly receiving cash (from sales, debtors and perhaps even from interest), and constantly using cash (paying bills, paying staff and so on) it needs to ensure that the two balance out. The consequences of a mismatch of the two should be obvious. Think of it in terms of your own bank account and you will see what I mean. More money going out than coming in quickly leads to bouncing cheques and 'persuasive letters' from the bank manager. The same will happen to a firm and it will run into cash flow problems.

A firm needs therefore to plan its cash flow carefully, and this should be in the form of a cash flow forecast. This will set out all incoming cash from any form and when it is coming in, and all outgoing cash and when it is going. A sample is shown below:-

	January	February	March	April	May	June
Balance b/f	100	100	75	(150)	........	........
INCOMING
Sales receipts - cash	500	600	700	........	........	........
Sales receipts - credit	275	325	350	........	........	........
TOTAL CASH	875	1025	1125	........	........	........
OUTGOING
Wages & salaries	300	350	400	........	........	........
Bills	150	275	375	........	........	........
Raw materials	200	225	250	........	........	........
Other expenses	125	100	250	........	........	........
TOTAL OUTGOING	775	950	1275	........	........	........
Balance c/f	100	75	(150)	........	........	........

As you can see - although the firm was selling very well in February and March, it nevertheless ran into cash shortages because of a high level of expenses. If it was able to foresee this by planning ahead with a cash flow forecast, they would be able to arrange for short-term finance to tide them over. They will get a far more sympathetic response from the bank if they go in well in advance than if they go in in a panic when they actually run out of cash.

Source:
http://www.bized.co.uk