BThe success of a business consists of doing several things well. We first talked about the creation of value, which must be desired by your target customers who will be ready to pay you a profitable price. Beyond creating value at a profitable sale price, sustainable business success relies on asset growth built from earnings that are backed by cash. Today we will discuss cash management.
One of the principles of modern accounting is the concept of “accounting”. This principle of accrual accounting requires that financial transactions be recorded in the period in which they occur, regardless of when the money for the transaction is received or paid. The goal is to match income to expenses when transactions occur rather than when payment for the transaction actually occurs. Although the principle of accrual accounting helps us understand the financial position of a business at any time, it does not show us what the actual cash position of the business is. This means that a company can show profits on its books but can go bankrupt due to lack of cash! Therefore, it is crucial to understand what cash flow is, its management and its importance.
Cash cycle: A company’s cash flows are reasonably predictable. We either obtain supplies and services on credit or pay for them in cash (which includes payments through your bank accounts). Likewise, we also sell our products (goods and services) on credit or in cash (which also includes payments made through your bank accounts). How we manage our sales receipts and make payments for the goods and services we purchase determines our cash conversion cycles and our net cash position at any given time.
The common example given to explain your cash flow and cash position is to imagine a bathtub that you can let water in and out of and drain the water from, with the net water level representing your net “cash position” at any time. . The more water (i.e. cash) you want in the tub, the more tap water you have to let in (i.e. more cash from sales, investors, creditors, etc.), but at the same time you have to slow down the evacuation (i.e. by delaying payments to suppliers of goods and services). A caveat at this point, however, is that no matter what you do to slow cash outflows, you should always meet the payment terms agreed with your suppliers. If, for unexpected legitimate reasons, you are unlikely to meet the terms, which should be an exception, you must negotiate and agree to new terms. Your credit reputation with suppliers is very important to your success. More of this will be discussed later in this series.
Understanding the cash cycle means you need to understand the cash conversion process including working capital and even capital investment management. Assuming your capital investment decisions have been wise, prudent and optimal, you should be excellent at managing your working capital by dynamically understanding the impact of your inventory, accounts receivable and accounts payable on your cash position. .
Key Terms: You need to understand basic working capital terms:
Liquidity refers to the ease with which an asset can be converted into cash without negatively affecting its market value. Being “liquid” means having cash and near-cash that you can always draw on to settle your obligations as they come due and take advantage of opportunities.
· Cash and bank balances refer to the cash you have in the office cashbox, the safe, and in your bank accounts at all times. Generally speaking, it is the most liquid of all your assets.
· Accounts receivable are debts owed to your business by your customers who have received goods and services but have not yet paid you. (Note that this applies regardless of whether the goods and services have been used by customers or not, unless there are terms to the contrary.)
· Inventory includes various groups of materials and other consumables that are used to produce goods and services. This includes raw materials, work in progress, finished goods and certain other consumables (referred to as “maintenance, repair and operating supplies”). Typically, your inventory turns into final merchandise available for sale to your customers.
“Other current assets”: Essentially, your cash/bank, receivables and inventory make up the bulk of your “current assets”. But outside of these three broad categories, there may be other “current assets” that your business might hold, such as marketable securities, prepayments, etc. The sum of all these assets forms what is called your current assets.
· Accounts payable are short-term obligations owed to your suppliers and other creditors. If your raw material supplier supplies you with goods for which payment will be made at a later date, you have a trade debt that will be due on the agreed future date.
· Current liabilities are your short-term financial obligations that will mature in one year or within a normal operating circle. Besides your accounts payable, other current liabilities include accrued liabilities, taxes payable, short-term debts, etc.
Your net working capital is the sum of all your current assets minus the sum of all your current liabilities. While different short-term assets and different short-term liabilities have a different impact on your liquidity position, it is necessary for you to understand what each means and how each impacts your operations. In fact, beyond understanding current assets and liabilities for cash management purposes, you should also be thoroughly familiar with financial statements including income statements and statements of financial position.
Next week we will discuss the importance, principles and practices of cash management.