Masterclass: Cashflow is the lifeblood of companies

Masterclass: Cashflow is the lifeblood of companies

Professor Arif Khurshed is the Associate Head of Research for the Accounting and Finance Division at Alliance Manchester Business School. His research interests span corporate finance, including IPOs, venture capital, payout policy, and trade credit. He is also the author of the book ‘The Mechanics and Performance of Initial Public Offerings’. Arif has a passion for teaching and has been the recipient of a number of faculty outstanding teaching awards. He is on the editorial board of the British Accounting Review and the newly launched Journal of Sustainable Finance and Accounting. Previously, he served as an academic member of the International Valuation Standards Council and as an external consultant to the UK Financial Conduct Authority and the British Venture Capital Association. He also has been called as an expert witness in corporate litigation.

“Coming from a business school and having worked in accounting and finance all my professional life, here's a topic which we know about but we usually don't speak much about - how we actually manage cash in our firms.

When we run a firm, we are always looking into cash outflows and inflows. In other words, we are managing the working capital – the accounts receivable plus any inventory that you have, minus accounts payable. All of these factors change on a regular basis. Today, you receive some money from your client. Tomorrow, you have to make a payment to your supplier. Inventory levels go up and down, so working capital is always changing.

Our job as a finance manager is to make sure that there is enough cash at hand so that the company does not run out of cash. But too much cash is also problematic because there are negative consequences of holding cash.

We can understand how a company is doing with its cash flow management through reports about their cash positions in their annual accounts. You will see the balance sheet, income statement and you will also have the cash flow statement. We can really read between the lines and understand the financial performance of the company and have a sense of the importance of cash management and what it really entails.

Cash is still king – and vital to companies

Cash is so important for the lifecycle of a firm. The cash balance of a company is at the heart of all the activities. When you sell goods and services, there's a cash inflow. Shareholders, when they buy shares also provide capital. When bondholders buy bonds, they're also providing an inflow of capital to the firm. And sometimes governments provide subsidies.

But money is also going out because you have to pay your suppliers, your employees, your taxes. When you spend money on capital expenditure, you pay for that too. And from the profits you make as a company, you pay your shareholders dividends and your bondholders the coupons or the interest that you have promised.

But there are two other players that we usually don't think about – your company’s bank and the financial markets. Cash management is invariably also about managing bank relationships and inflows and outflows. If you have excess cash, you need to be doing something with it because there is a time-value to money. This is how cash moves and unfortunately, these movements are not synchronised, so cash inflow and cash outflow may not always match. This is where the problem of cash management actually lies.

What is cash?

What do we really understand about cash? What does cash actually mean? In fact, cash is a surprisingly very imprecise concept. In the economic definition of cash, we include not only our current accounts at banks but also the currency we may have or undeposited cheques. As a finance manager, your definition of cash is broader and may include short term marketable securities, ‘near cash’.

Why do companies hold cash?

Companies hold cash because of transactions. We have to make payments, receive payments, pay our employees. We need cash so that the obligations of the company are met well in time. But then there are other reasons why a company may hold cash.
It's also a precaution for things that you do not foresee, so you keep some cash balance as a buffer for hard times and to keep the company operating.

The third reason for holding cash is speculation. We look for opportunities – to buy raw materials cheaply or look at bankrupt companies with assets for sale. So, it’s prudent to keep some extra cash to be able to do that deal.

We don’t usually don't think about the fourth reason - the compensation balance model. Companies sometimes have to keep cash as part of their banking relationship. Is this a good thing? It’s debatable but you have to make sure that you do the cost benefit analysis.

Planning ahead is key

Cash management is concerned with planning.

To summarise the objectives of cash management, the first is to make sure that a company has the capability to pay its obligations on time. The second is to make sure that funds are available at the right time, at the right place, and if you are a multinational firm in the right currency and at an acceptable cost.

You plan well ahead so you need to have a view of expected transactions… you can implement the cash management strategy. But your job is not done. You then monitor things and make adjustments as situations change, while managing what is called your liquid resource - enough cash to pay your taxes, employees, utility bills on time – and minimising your idle balance.

Achieving good cash management needs a multi-pronged approach and this is the job of a cash manager or a finance manager.

Can you have too much cash?

We talk about a firm being very liquid but what does it really mean? We have a conundrum because cash pays almost no interest. So, why do some companies hold billions of dollars in cash and in demand deposits?

in 2011, Apple held more cash than the US Federal Reserve. Recently, it was reported that the top 13 companies in the US hold more than 1 trillion US dollars in cash.

The question is, why?

General Motors’ most recent figure is they hold around 26 billion US dollars in cash. The reason is that cash gives you more liquidity than securities or any other investments. And you have to justify this to your clients, your customers, shareholders and stakeholders.

Does it really matter how much cash our company keeps? The answer is yes and the rationale is the marginal value of liquidity. When a company holds a small amount of cash, a little extra would be seen as extremely useful. Whereas if you hold large amounts of additional liquidity, any more cash is not worth much. Therefore, it's really important for good cash managers to make sure that we have the right level of cash in our company. The science behind cash management is that we want to hold cash balances up to the point where the benefit of holding cash, which is the marginal utility of liquidity, is equal to the value of the opportunity cost. What we could have done with the money had we invested it somewhere else?

And finding that right balance is not easy because companies are unique, and their opportunities and circumstances change.

Cash budgeting and inventory

Your role as a finance manager is to forecast the future sources and uses of cash. Forecasting allows you to identify short-term financial requirements or any surpluses based on your company's budgeted activities.
Cash budgeting has four simple steps. First, forecast the anticipated cash inflows over the forecast horizon. Second, forecast the anticipated cash outflows of your company. Step three, you put all these together to get your anticipated inflows and outflows. And lastly, you calculate your cumulative cash flow at the end of the week, month and thereafter.

Once you have a cash budget, it helps you to identify future cash flow problems. It not only gives you time to prepare for it but understand it. Why is my company going to face this crunch for the remaining four or five months? What is leading to this possibility where I have a negative cash balance? This is how managers try to understand cash flow management and to some extent prepare for the near future.

Inventory is a major component in cash flow analysis and if you do not manage your inventory well, this can create major problems for your firm. There is a whole science behind inventory management and the idea is to minimize the cost of investment in inventory – when to buy and pay for raw materials. The management of inventory plays a very important role in a company's cash flow timeline.

Cash flow statements provide the clues to company health

We can really figure out the cash flow situation of a company by looking at the annual report and the cash flow statement. This pulls data from the balance sheet and the income statement and is made up of three parts - cash from operating activities, cash from investing activities and cash outflow from financing activities. There’s a lot of data in there and making sense of it helps you understand how the company is performing. There are some clues to look out for.

Cash flow statements provide an insight into the cash position of a company. The golden rule for cash management is to expedite cash inflows and slow down the cash outflows as much as you can. It may not always be possible but it is worth trying.
My own experience and attitude, as a teacher at the University of Manchester, when we talk about cash management and the skills we need, is to first highlight a business management problem, look at the science behind it, then look at how we apply our understanding and knowledge to solving the real problem. This is what we call the Manchester Method (learning by doing).