Cash Management

Cash is the life blood of any business. Decisions regarding the level of cash balance to maintain, when and how to make cash transactions and where to put any excess cash are critical value-adding activities.

When a company manufactures its products, cash is tied up in inventories. When products are sold on credit, cash is frozen up in accounts receivable. Often raw materials and other factors of products are obtained on credit which is a free source of cash. Cash tied up in inventories and accounts receivable earns no return, so businesses should try to sell products quickly, collect cash as early as possible and pay creditors/suppliers as late as possible unless the discount available is sizeable enough. Cash conversion cycle is an important measure used to assess just that. It equals net days in which a company converts inventories to readily available cash and it is calculated as follows:

Cash conversion cycle
= days inventories outstanding
+ days sales outstanding
days payables outstanding

Cash Balances

Businesses keep three type of cash balances:

  1. Compensating balances
  2. Precautionary balances, and
  3. Speculative balances

Compensating balances represent the minimum cash balance which a company has to keep in its bank account under any loan arrangement with a bank.

Precautionary balances are cash balances maintained to provide liquidity in case of extraordinary situations such as strikes, disasters, etc.

Speculative balances are cash balances maintained to avail any opportunities that might arise (for example to claim a cash discount if the discount rate offered is higher than the opportunity cost of cash).

Cash balances kept must be such that the financial value for total opportunities availed (discounts or speculative profits) exceeds the interest that might have been earned by putting that money in an interest-earning bank account. This is the theoretical framework that should guide the cash management process. Cash management process involves preparation of a detailed cash budget [/managerial/master-budget/cash-budget] to work out future net cash flows, identify any cash shortage or excess and take appropriate action.


The single most important cash management principle is to effectively manage float. Float is the time it takes in issuance, distribution and clearance of checks.

Businesses adopt techniques that minimize float in receipts from customers (called collections float) and maximize float in payments to customers (called disbursements float).

Collections float can be minimized by adopting the lockbox system and/or concentration banking. In a lockbox system, customers are required to mail all their checks to a specified bank, which receives the checks and starts their clearance right away. Float is reduced because company staff is no longer required to receive checks and then send them to bank for deposit. In concentration banking, customers are asked to mail checks to the nearest branch of the company, which deposits checks in their local bank account. Since checks are not required to be mailed to the headquarters, the time between issue of check by customers and deposit in the bank account is reduced. Any excess funds in the local bank accounts are moved to the central bank account periodically.

Disbursements float can be maximized by maintaining dedicated bank account in a bank that takes longer in clearing checks issued to customers and transferring only such amount to that bank daily for which the bank has received checks. Keeping in view the credit terms, payments to customers should be issued on the last day of the discount period where discount rate is large enough, else payments should be made on the last day of the credit period.

Surplus cash

Any surplus cash is invested in marketable securities depending on the duration the cash is available, risk tolerance of the company and return available.

For example, where cash is available for very brief time, very liquid and very secure marketable securities such as treasury bills should be purchased. Where cash is available for fairly long period, money market mutual fund investments might be a good idea. Other potential securities classes in which excess cash can be invested include commercial paper, certificates of deposit (CDs), etc.

Written by Obaidullah Jan, ACA, CFAhire me at