Question

Cash Management

Discuss how companies manage their cash distributions and the importance of cash management. How is it possible for a company to be profitable but cash poor?

Answer 1

Answer:

Cash management is the key to any business. Business needs generate cash to meet their expenses and pay off its liabilities and also for the expansion of business.

It is important for a business to maintain certain level of cash balance everytime so as to meet the emergency requirements. Maintaining cash balance is also important from the view point of debtors too. Debtors too have a say in the running of a business. If company meets its expenses through cash rather than taking debt, it will indicate a strong financial position of the business. Cash management is important for carrying its routine activities like payment of salaries, raw material purchase, electricity expenses, rent etc.

Also, companies are required to prepare cash flow statement which shows the data regarding the cash inflows which the company is generating from its operations and also from external sources. It also shows cash outflows and the investments made by a company during a period. A cash flow statement captures the flow of cash from operating, investing and financing activities.

Accounts receivables also have a great impact on the management of cash. Companies should ensure regular inflow of cash and keep a stringent credit policy and not offer credits indiscriminately to its customers otherwise it would cause slower inflow of cash to them.

Companies are required to maintain a perfect balance of cash in hand. Too much cash in hand will deprive them of good investment opportunities. Cash should be maintained enough to meet the expenses and some buffer amount to meet the emergency requirements. Any surplus amount left should be invested in profitable opportunites to generate income on a regular basis.

It is possible for a company to be profitable but cash poor. It happens because the companies are required to follow the accrual basis of accounting. Accrual basis of accounting does not involve actual cash receipts or cash payments.
Let's understand it with a simple example: Say a company has sold goods worth $10,000 to its customers on a 2- month credit policy. It also incurred expenses of $2,500 out of which $500 is paid at the moment and remaining will be paid in 1 month. Now as per accrual basis of accounting, company has earned a profit of $7,500 [$10,000 - $2,500] but in terms of cash it has made a payment of $500 having $0 receipts in hand. From financial statements, it can be seen that company is making profits but if you analyse the cash flow statement you can see that company has a negative balance of -$50. (This is a small example assuming that company has only two transactions just to show the difference between accrual and cash basis of acounting). In this way, we can see that company is profitable but cash poor.