Cash Management : Objectives, Importance, Functions, Work, Types & Examples - GeeksforGeeks (2024)

What is Cash Management?

Cash management refers to managing a business’s cash flow to make sure that it has enough funds to function in its daily operations. It suggests the utilisation of cash to ensure maximum liquidity and profitability. Cash management is concerned with monitoring, analyzing, and managing cash inflows, outflows, and cash balances held by the firm at a certain point by financing the deficit or investing surplus cash. Management of cash is an essential component of overall work­ing capital management since cash is the most liquid type of current asset. It is a key factor in the financial stability of an organisation.

Geeky Takeaways:

• Cash management, also known as treasury management, is a process that involves determining and managing the cash flow which is
• In cash management, the word cash not only includes money in the form of currency but also includes liquid assets like marketable securities and time deposits.
• It aims to ensure that a company’s funds are not idle and are being used efficiently to maintain a sound cash flow position.
• The cash flow statement is the main element of corporate cash flow.

Objectives of Cash Management

The primary goal of cash management is to maintain adequate liquidity in a firm to meet its day-to-day obligations while utilising surplus cash to give rise to returns. Other objectives of cash management are discussed below,

1. Meeting Obligations: Cash management needs to be done in the right manner by a business to meet its short-term and long-term obligations.

2. Instigate Investment: Cash management encourages investing the surplus cash in the right place and in the correct proportion to make efficient use of the funds of the company.

3. Optimizing Cash Holding: The finance manager must decide the optimal cash holding to avoid any excess or deficit. It means determining the appropriate amount of cash needed to be kept in the business to meet the contingency needs.

4. Avoiding Insolvency: It aims at reducing the risk of insolvency which may arise due to lack of liquid assets or not making a profit out of surplus funds.

5. Proper Planning: Cash management involves anticipating when the organization may need additional funds or when excess cash may be available and also helps in planning the capital expenditure.

6. Handling Unorganized Costs: Cash surplus becomes a lifesaver where the condition of unforeseen expenditure occurs. Effective management of cash helps the business to cope with these situations.

Importance of Cash Management

1. Liquid Asset: Cash is the lifeblood of any business as it is needed to acquire resources, make transactions, pay off debts, etc. A business will not generate profit if the cash is held idle and on the other hand, if there is a cash deficit then it may cause an irreplaceable loss to the business. Therefore, proper management of cash flow is essential to have a profitable business.

2. Adequacy of Funds: The availability of cash is necessary for purchasing assets, making investments, reducing liabilities, etc. A business needs to make sure that there are adequate funds to meet its current obligations and make proper reserves to meet any future contingencies.

3. Working Capital: As cash is the most liquid asset, it has a major role in working capital management. Hence, the business needs to manage cash in a way that maintains the liquidity position without affecting profitability.

4. Reducing Risk: With accurate forecasting and making cash reserves accordingly, a business can overcome unforeseen circ*mstances. It helps in assessing and reducing the risks related to cash and implements internal controls to safeguard cash assets.

5. Planning: It involves anticipating when the organization may need additional funds or when excess cash may be available. Proper planning makes the entity ready to face challenges and unwanted situations.

6. Relations with Stakeholders: This strengthens the relationships between the company and its stakeholders and leads to more favourable terms. A business can enhance its credibility by timely payment of bills, and salaries, and by performing other financial obligations

Functions of Cash Management

Cash management plays an important role in managing the finances of businesses or individuals. As discussed above, this involves accumulating, managing, and disbursing cash to create liquidity in the business and boost profitability. The main functions of cash management are,

1. Liquidity Management: Liquidity means the amount of cash and cash equivalents held by a company for its day-to-day operations and smooth working. Cash management ensures that there is enough cash in hand to meet daily operational needs. It also balances the need for liquidity with the opportunity cost of holding idle cash.

2. Receivable Management: Cash management plays the function of faster recovery of receivables to avoid a cash crunch and to maintain liquid cash. If the average time for recovery is shorter, the organization will have enough cash in hand to pay off its debts.

3. Investments: It is important to invest the surplus cash in hand wisely. The company needs to look for various short-term investment alternatives to utilize surplus funds. Management helps in investing with maximum returns without compromising the liquidity of the business.

4. Compliance: Effective cash management shall fulfill all the compliance with regulatory requirements related to cash handling and reporting. It keeps us informed about changes in financial regulations that may impact cash management practices.

5. Risk Management: Businesses need to monitor their system timely to avoid the risk of bankruptcy. Cash management assesses and reduces the risk related to cash and forms internal controls to safeguard cash assets.

How does Cash Management Work?

Cash management involves effective planning to maintain adequate cash flow and liquid assets in the company. Strategic planning contains the following,

1. Cash Forecasting: Budgeting and Forecasting are parts of cash management strategy. Based on the forecasting, the company maintains a budget for future expenses and daily operations. The company assesses various sources of cash inflows and expenditures.

2. Lowering Costs: It is the key aspect of cash management. To increase the profit margin and conserve cash, a company needs to identify unnecessary expenses and try to lower them.

3. Bank Relations: Making good relations with banks and other financial institutions, helps businesses negotiate for various banking services, interest rates, granting loans, and have the most favourable terms.

4. Cash Reserve: A business needs to make proper cash reserves by setting aside money to meet any future contingencies. A cash reserve can be in the form of a general reserve or free reserve. During excess reserve, the company may decide to declare an interim dividend, which positively affects the goodwill of the company.

5. Monitoring and Adjustment: Regular monitoring and adjusting the cash flow will help the business adapt to changes quickly and foresee the expenses and various ways of generating the funds.

Examples of Cash Management

1. Efficient Invoicing: A business can implement efficient invoicing processes by using automated payment reminders to ensure timely collection from customers and offering discounts for early payments.

2. Budgeting: It means proper planning for expenditure. Making a detailed cash budget that sets out the planned structure for cash inflows and outflows can help the business allocate resources effectively and avoid unnecessary expenditures. It also encourages the growth of the business at a constant rate.

3. Working Capital: It is necessary to efficiently manage the working capital by optimizing inventory, shortening the receivables, and negotiating favourable terms with creditors to improve the overall cash flow of the business.

4. Cash Reserve: A business needs to make proper cash reserves by setting aside money to meet any future contingencies. A cash reserve can be in the form of a general reserve or free reserve. During excess reserve, a company may decide to declare an interim dividend, which positively affects the goodwill of the company.

Types of Cash Management

1. Cash Flow from Operating Activities: Operating activity means the functions that are carried out by a business daily. The operating cash flow is represented by the cash flow statement of the company which shows how much money is being generated from regular business activities over a certain period. In simple words, it shows the cash flow from its core business activity and does not include revenue from investments and long-term expenditures.

2. Free Cash Flow to Equity: It reveals the company’s financial health and its capacity to meet its obligations to equity shareholders. It represents the cash that is available to be distributed to its equity shareholders. The cash can be distributed to the shareholders in the form of an interim dividend or final dividend.

3. Free Cash Flow to the Firm: It is the amount of cash derived from the operations of the company that is calculated after allowing depreciation and paying off the taxes. It is also essential in assessing the company’s financial state and capacity to meet its obligations. This form is used in financial modeling and valuation.

4. Net Change in Cash: It represents the difference or ‘Net Change’ between two accounting periods. It depicts the overall increase or decrease in the company’s cash and cash equivalents during a period.

Cash Management Strategies

1. Cash Sweep Accounts: Using cash sweep accounts to automatically transfer excess funds to interest-earning accounts maximizes returns on idle cash. A sweep account is a bank account that transfers funds that fall short of a certain threshold or surpass it, into a higher interest-earning investment option, at the end of a day.

2. Employee Training and Awareness: To foster a culture of cost-consciousness and cash responsibility within the organization, training and educating employees on the importance of cash management and their role in optimizing cash flow becomes necessary. Training of the personnel will improve efficiency and funds of the company can be utilised in a better manner.

3. Centralized Cash Management: This includes consolidation of funds into a master account for efficient management. Centralizing the cash system will have better control and visibility over cash positions. It will also help to keep track of funds in a better manner.

4. Technology Integration: Leveraging technology for electronic payments, online banking, and cash management systems will save time and introduce ease of doing business. It encourages automation of various tasks that helps companies to become more efficient with their resources.

5. Short-term Investments: Short-term investments are those which can be easily converted into cash. These are also known as cash equivalents. Investing in short-term instruments helps in generating funds which helps in maintaining liquidity and cash reserve.

What does Working Capital Include?

Working capital means capital available with the company to meet its current and short-term obligations and to run daily operations. The difference between the current assets and current liabilities of the company is working capital. It includes the following:

1. Current Assets: Current assets are those assets that are highly liquidable. Current assets include the following,

• Bills Receivables: Money owed to the company by customers for goods or services delivered on credit.
• Short-Term Investments: Investments that can be quickly converted to cash within one year.
• Prepaid Expenses: Payments that are made in advance for goods or services that are to be received in the future are prepaid expenses.
• Cash and Cash Equivalents: Money in the form of physical currency, cash at the bank, and highly liquid investments with a short maturity period.

2. Current Liabilities: Current liabilities are short-term financial debts that a company needs to pay within one year. Current liabilities include:

• Accounts Payable: Amounts owed by the company to suppliers and vendors for goods or services received on credit.
• Short-Term Debt: Debt obligations with a maturity period of one year or less.
• Accrued Liabilities: Expenses that have been incurred but not yet paid, such as accrued wages or utilities.

Benefits of Cash Management

1. Capital Management: As discussed earlier, cash is the most liquid asset, therefore, it has a major role in the working capital management of the company. It involves forecasting the need and amount of funds required for maintaining smooth operations and maximising profitability.

2. Adequate Funds: The business needs to ensure that there are adequate funds to meet current obligations and proper reserves to meet future contingencies. Proper availability of funds is necessary to carry out daily activities and reduce liabilities.

3. Liquidity Management: Cash management ensures that there is enough cash in hand to meet daily operational needs. Accurate cash flow data can give a better understanding of liquidity risks associated with the business. Cash management also balances the need for liquidity with the opportunity cost of holding idle cash.

4. Risk Management: Businesses need to monitor their system timely to avoid the risk of bankruptcy. With accurate forecasting and making cash reserves accordingly, a business can overcome unforeseen circ*mstances. Cash management assesses and lowers the risk related to cash and implements internal controls to safeguard cash assets.

5. Cash Reserve: Maintaining sufficient cash reserve can save a firm from unforeseen expenses and contingencies. Entities can also use their cash reserve to expand their business or declare dividends which will enhance their goodwill in the market.

6. Cost Saving: Proper management of cash flow saves costs by avoiding late fees, penalties, and interest expenses. With the standardization and automation of cash management processes, businesses can save a significant number of hours for their finance team which can be used in other work.

7. Strategic Investments: It ensures strategic planning for the investment of funds which contributes to the long-term growth of business.

Limitations of Cash Management

1. Opportunity Cost of Holding Cash: Holding excess cash for precautionary reasons incurs an opportunity cost, as funds could potentially be invested to generate returns. Striking the right balance between liquidity and investment opportunities is challenging.

2. Interest Rates and Inflation Impact: Fluctuations in interest rates and inflation can affect the returns on short-term investments and the real value of cash over time. Low-interest-rate environments may limit the earnings potential on idle cash.

3. Economic Uncertainty: Economic uncertainties can impact the predictability of cash flows and make it challenging to plan for cash needs accurately. It may affect the cash management strategies.

4. Seasonal Variations and Business Cycles: Businesses with seasonal variations may experience uneven cash flows throughout the year. It can be complex to accommodate the cash management strategies with these fluctuations.

5. Credit Policy Impact: Offering loose credit terms to customers may result in delayed receivables, affecting the cash conversion cycle and leading to cash flow challenges.

6. Market Fluctuations: Economic fluctuations and unfavourable market conditions may impact the value of the investments made by the company. These uncertain conditions can affect the liquidity of the company and its capacity to meet contingencies.

7. Technology: Relying heavily on technology becomes risky as it exposes the entities to various downfalls of technology such as cyber threats, hacking of data, or technology failures.

How to Improve Cash Management?

There are many ways through which we can improve cash management. Some of them are discussed below:

1. Accurate Cash Flow Forecasting: Making accurate cash flow forecasts by regularly updating financial models and by using market trends, business intelligence, and forecasting tools or software.

2. Explore Short-Term Investments: Businesses should identify suitable short-term investment opportunities for engaging surplus cash. Firms can also use money market instruments, certificates of deposit, or other low-risk investments to earn additional returns.

3. Effective Communication with Stakeholders: Maintaining open communication with customers, suppliers, and financial institutions helps negotiate payment terms and conditions when necessary.

4. Working Capital Optimization: Evaluation and optimization of working capital by balancing current assets and liabilities can help in improving cash management. It will minimize the time between paying for inventory and receiving cash from sales.

Creating Cash Reserve: Cash reserve ensures liquidity in the business and acts as a lifesaver in case of unforeseen circ*mstances.

Frequently Asked Questions (FAQ)

1. Why is Cash Management Important?

Answer:

Cash management plays a crucial role in managing the finances of businesses or individuals. This process involves accumulating, managing and disbursem*nt of cash to make liquidity in the business and boost profitability.

2. What are the key components of cash management?

Answer:

The Key components of cash management include accumulation, disbursem*nt, forecasting, budgeting, and investment of cash.

3. What is a cash flow statement?

Answer:

A cash flow statement is a financial statement that shows the total cash flow of the company. It also represents the operating cost of the business.

4. What are the risks of poor cash management?

Answer:

Poor cash management can lead to insolvency, missed business opportunities, increased borrowing costs, and damage to the company’s credit rating.