Question

Creative Corporation manufactures children's toys. Creative has significant debt outstanding that has been used to buy equipment and inventory used in its manufacturing process. Creative has positive cash from operating activities during the holiday season (November and December), but negative cash from operating activities during the months preceding the holiday season. Meanwhile, Technology Inc. is a mature, successful software development company with no debt outstanding and very few non-current assets. Which company requires a higher amount of cash on hand? Discuss, in general terms, how much cash each firm should have on hand for effective cash management.

Answer 1

Solution:-

A higher level of cash on hand serves the purpose of providing buffer in troublent times. High levels of Debt and loss making operations are two of the primary factors that give troubles to businesses.

As we can see that creative corporation has high debt and also operations that turn losses for majority of the year. On the contrary, Technology Inc. is a stable business with healthy operations and no debt.

Clearly, Creative Corporation requires a higher level of cash hand due to their higher chances of getting into financial stress as compared to Technology inc.

Appropriate cash levels in general:

There is actually a no 'one size fits it all' level for cash in hand. It completely depends on the nature of the business and financial & operating situation at hand.

Let's not forget that more is not always better when it comes to cash on hand. This is because excess cah just earns normal bank interest instead of being parked in more productive operating assets and earning high returns on capital. Therefore, more is not always better and all businesses must identify their individual needs related to cash in hand and keep a level that is enough to provide cushion against any financial uncertainty while still not be unreasonably excessive.

Few factors that determine the level of cash in hand required are as follows:

• Net profit margins/operating cash flow of the business
• Stability of working capital constituents, such as recovery from debtors, requirements of inventory, credit period from creditors, etc
• Leverage or debt levels in the business
• Competitive pressure on margins
• Cyclical nature of business. If the business is cyclical, the company must be more cautious related to uncertainties
• Degree of operating leverage, i.e. level of fixed costs in the business