In: Finance
A company that produces racing motorbikes has several models that sell well within the motorcycle racing community and which are very profitable for the company. These motorbikes are sold to retail customers and also business customers who were provided with 60-day credit terms. Despite having a profitable product, why must this company take care to ensure that it has sufficient cash on hand to meet its obligations?
(a) The company will have built up debts which must be repaid in order to bring the current models to market.
(b) Profits from the sales of popular models will be lost when returned to the shareholders in the form of dividends.
(c) Profits are not necessary reflected in the current cash balance of its bank account.
(d) Equity must be raised to finance the development of new models to replace the existing models.
The correct option is :-
(c) Profits are not necessary reflected in the current cash balance of its bank account.
The motorbike company is selling all its products to both retail & business customers on 60- day credit terms. So, the company is not receiving the cash instantly after selling the motorbikes. On the other hand, to maintain a required level of liquidity and carry on the day to day business operations the company requires sufficient cash in hand. Also, to build up new models and bring them into the market requires lot of money before the company can actually start earning some revenue from them. Thus the company needs to have a good cash management system in place.
Cash management is one of the key areas of working capital management. Besides being the most liquid current asset, cash is the common denominator to which all the current assets can be reduced because, the other liquid assets like receivables and inventory eventually get converted into cash. As we know, there are four primary motives for any business for maintaining cash balances. They are:-
1) Transaction motive – It refers to the need of holding cash balance to meet the routine requirements of cash to finance the transactions that a company carries on during its ordinary course of business. For example, cash payments have to be made for purchases, wages, operating expenses, financial charges like taxes, interests, dividends etc.
2) Precautionary motive – Since, there is always a non-synchronization between cash inflows & outflows, there are also certain future events that one cannot anticipate or predict. Unexpected cash needs may arise on short notice due to events like floods, strike, failure of payment from bulk customers, sharp increase in prices of raw materials, cancellation of orders, sudden economic downturns etc.
3) Speculative motive – It refers to the strategy of a firm trying to take advantage out of certain opportunities that may turn up at unexpected moments and which are typically outside the normal course of business. For example, an opportunity to purchase raw materials at reduced price on immediate payment of cash.
4) Compensating motive – This is to hold a minimum amount of cash balance in the banks in order to compensate them for providing certain services and loans. Usually clients are required to maintain a minimum account balance in the banks. Since this cash balance cannot be utilised by the firms for transaction purposes, while the bank themselves can use the amount to earn a return. Such balances are compensating balances.
A very important point to take note of is that the amount of profit a business firm makes does not necessarily get reflected in the cash balance of its bank account. This is because profit has simply no connection with the bank balance. When a firm prepares its income statement, it gets the gross profit amount from its trading activities, by subtracting the cost of sales from the total sales amt. Then it subtracts its operating expenses like rent, salary & wages, interests, telephone & stationery costs, rents etc. from the gross profit to finally arrive at the net profit or loss amount. However, this net profit actually shows the net results of the revenue and expenses of the business over a period. But the net profit figure & the cash flow balance are not the same. There is always non-synchronization between cash inflow and outflow.
For example, when the motorbike firm generates an invoice of $50,000, this gets recorded in the P/L account and is shown as an income. No expenses have been made yet by the firm. So this $50,000 is shown as the net profit on the P/L account. However, no payment has been yet received from this invoice due to the 60day credit term and hence; the cash balance in the bank is also not credited. On the other hand, out of that $50,000 net income, the firm starts paying its operating expenses. Thus while the operating expenses get piled up in its P/L statement, its bank cash balance also gets depleted. The P/L account is showing both type of transactions, earnings and expenses while the bank balance is only showing the debit figures. This is because the company has not yet received that $50,000 deposit.
The situation of a business having positive profit figures while having a negative cash flow balance occurs due to accounting issues. It is due to the difference in the timing of when revenues & expenses are recognized in relation to their actual collection & payment. As per the accounting standards, the businesses generally maintain their accounts on accrual basis, where the revenues are recorded when sales happen irrespective of when the company actually receives the cash in hand. Similarly, expenses are recorded when they get due regardless of when the bill actually got paid. Hence, small businesses follow cash basis accounting which always gives an accurate reflection of the cash balance in the bank. However, it doesn’t hold good for the large firms since it doesn’t show the true profit of the business for an accounting period. Hence, the matching principle is the best standard accounting principle in which the expenses are matched with the revenues for the reporting period.