Question

QUESTION 1

REQUIRED
In view of the information given below, answer the following questions:
1.1 Explain THREE (3) costs or risks to businesses of holding little or no cash.
1.2 Explain THREE (3) motives for holding cash.
1.3 What advice would you offer financial managers to ensure the effective of cash?

Answer 1

1.1)..costs or risks to businesses of holding little or no cash

Let’s look around to see if you’re ignoring any basic principles that can maximize your business value and your personal net worth. The objective in strategic wealth management is to integrate your business plan with your personal financial plan together to arrive at your life-plan goal. Too often, business executives and owners treat their personal goals separate from their business goals, operating each in a vacuum. Different sets of criteria are used to evaluate achievements in both business and personal arenas, and this further polarizes the strategies, causing a disconnect in achieving your ultimate financial and life-plan objectives. What risks are inherent in your personal and business portfolios? Do you take risk in business and therefore choose not to take personal risk in your portfolio?

Rather than obsess and concentrate on more ways to reduce taxes, are you “missing the mark” in utilizing key financial metrics to measure the financial success of your businesses?

Let me introduce the financial metric use of excess cash. When is too much cash a problem?

How a company’s cash is managed is a critical job that most business owners do from an emotional perspective rather than a rational financial one. Poor cash management can harm the company’s performance in subtle ways as well as more obvious serious ways. It is not having too little or no cash — it is also having too much cash as well. It lowers the return on assets and it increases the cost of capital (just like increasing the cost of goods without an offsetting increase in the customer pricing).

Holding excess cash lowers return on assets, increases the cost of capital, increases overall risk by destroying business value, and commonly produces overly confident management. When the cash balance exceeds the actual working capital cash balance need, you have excess cash. This cash is not necessary to the firm’s financial operations. Increasing or decreasing excess cash balances is a leading indicator of future good or bad times for the company. When there is too much negative excess and decreasing cash generation, cash needs to be accumulated, but when there is excess cash balances and increasing cash generation, the excess cash needs to be invested or distributed. Let’s take the effects of excess cash one item at a time.

Let’s look first at the effect of excess cash on the return on assets (ROA). Assume a business has total assets of $1 million with cash making up 15 percent of the total assets or $150,000. Further, assume that the business has an annual after tax net income on an adjusted debt free basis of $100,000. That would result in the business having an overall ROA of 10 percent. If the business is only earning 2 percent annual interest on its portion of the total assets then the real effect of cash can be determined. In this example it is assumed that all of the cash is excess in order to illustrate without too much complication.

If the return on the cash is only 2 percent and the overall ROA is 10 percent then one would have to assume that the ROA would be higher if the cash could be eliminated from the total assets. When the cash is eliminated the total assets go from $1 million to $850,000. One more thing to look at: the interest income on the cash is now eliminated so the net after tax income needs to be removed. This would be around a net after tax interest income of $2,000. The total net income after tax now comes to $98,000 and that amount divided by $850,000 results in a new ROA of 11.53 percent, which is 15 percent higher than the original ROA.

Warren Buffet strives for a 15 percent return on his businesses — 15 percent on what? He is striving for a net 15 percent book value return on his equity. The remainder above the 15 percent, he distributes to shareholders. So if you had your financials analyzed, and you had excess cash flow, what would you do with the distribution? What about funding a pension/profit sharing plan, deferred comp for you, defined benefit plan, or other plans that now directly link to your retirement objective? Interestingly, the less excess cash retained in your business the greater the value you are building within your company. The greater the value you build, the closer your retirement goals come to being a reality.

1.2)..Motives for Holding Cash

Definition: The Motives for Holding Cash is simple, the cash inflows and outflows are not well synchronized, i.e. sometimes the cash inflows are more than the cash outflows while at other times the cash outflows could be more. Hence, the cash is held by the firms to meet the certain as well as uncertain situations.

1. Transaction Motive: The transaction motive refers to the cash required by a firm to meet the day to day needs of its business operations. In an ordinary course of business, the firm requires cash to make the payments in the form of salaries, wages, interests, dividends, goods purchased, etc.

   Likewise, it also receives cash from its sales, debtors, investments. Often the firm’s cash inflows and outflows do not match, and hence, the cash is held up to meet its routine commitments.

2. Precautionary Motive: The precautionary motive refers to the tendency of a firm to hold cash, to meet the contingencies or unforeseen circumstances arising in the course of business.

   Since the future is uncertain, a firm may have to face contingencies such as an increase in the price of raw materials, labor strike, lockouts, change in the demand, etc. Thus, in order to meet with these uncertainties, the cash is held by the firms to have an uninterrupted business operations.

3. Speculative Motive: The firms hold cash for the speculative purposes to avail the benefit of bargain purchases that may arise in the future. For example, if the firm feels the prices of raw material are likely to fall in the future, it will hold cash and wait till the prices actually fall.

   Thus, a firm holds cash to exploit the possible opportunities that are out of the normal course of business. These opportunities could be in the form of the low-interest rate charged on the borrowed funds, expected fall in the raw material prices or favorable change in the government policies.

Thus, the cash is the most significant and liquid asset that the firm holds. It is significant as it is used to pay off the firm’s obligations and helps in the expansion of business operations.

1.3)..Financial managers to ensure the effective of cash

1. Have a clear business plan
A business plan will establish where you are and where you want to get to over the next few years. It should detail how you will finance your business and its activities, what money you will need and where it will come from - see write a business plan: step-by-step.

2. Monitor your financial position
You should regularly monitor the progress of your business. On a daily basis, you should know how much money you have in the bank, how many sales you’re making and your stock levels. You should also review your position against the targets set in your business plan on a monthly basis - see cashflow management.

3. Ensure customers pay you on time
Businesses can run into major problems because of late customer payments. To reduce the risk of late or non-payment, you should make your credit terms and conditions obvious from the outset. You should also quickly issue invoices that are clear and accurate. Using a computerised credit management system will help you to keep track of customers’ accounts - read ensure customers pay you on time.

4. Know your day-to-day costs
Even the most profitable of companies can face difficulties if there isn’t enough cash to cover day-to-day costs such as rent and wages. You should be aware of the minimum your business needs to survive and ensure you do not go below this - see how to measure cash in your business.

5. Keep up-to-date accounting records
If your accounts are not kept up-to-date, you could risk losing money by failing to keep up with late customer payments or not realising when you have to pay your suppliers. Using a good record keeping system will help you to track expenses, debts and creditors, apply for additional funding and save time and accountancy costs - see financial and management accounts.

6. Meet tax deadlines
Failing to meet deadlines for filing tax returns and payments can incur fines and interest. These are unnecessary costs that can be avoided with some forward-planning. Keeping accurate records saves your business time and money and you can be confident that you’re only paying the tax you owe. Therefore, it’s important that you meet your obligations - see set up a basic record-keeping system.

7. Become more efficient and control overheads
Is your business operating at its most efficient? Saving energy and therefore money can happen by implementing changes in behaviour and using existing equipment more efficiently. It’s one of the easiest ways to cut costs. Areas to look at in an average office include heating, lighting, office equipment and air conditioning - see save money by using energy more efficiently.

8. Control stock
Efficient stock control ensures you have the right amount of stock available at the right time so that your capital is not tied up unnecessarily. You should put systems in place to keep track of stock levels – taking control of this will allow you to free up cash, while also having the right amount of stock available - see common business mistakes: poor stock control.

9. Get the right funding
It is essential that you choose the right type of finance for your business – each type of finance is designed to meet different needs. Smaller businesses usually rely more on business overdrafts and personal funding but this might not be the best kind of funding for your company - read business financing options - an overview.

10. Tackle problems when they arise
It is always very stressful facing financial problems as a business, but there is help and advice available to help you tackle them before it gets too much to handle so seek professional advice as soon as possible. There are also some initial steps you can take to minimise the impact such as tackling priority debts first and assessing how you can improve your cashflow management - see business debt: help and advice.