Cash management principles and practices

Cash Management should always take inflationary risk into account. The rate of inflation in an economy represents a devaluation of wealth in real terms. Prices increase during times of inflation. This is turn reduces purchasing power, since the same amount of money buys fewer goods.

For this reason, the cash management strategy at any firm should take inflationary pressure into account. It is necessary for almost any business to retain at least some cash on hand, for day-to-day spending needs. Cash, however, only retains its nominal value over time. One hundred dollars today will still be one hundred dollars a month from now. However, it may not buy as much. In the normal course of business, this devaluation of money over time is not a major concern. If the business is profitable, it is understood that all money invested into the business' operations will generate a return that is sufficient to cover inflation. This derives from the principle of rational decision making - if the activity does not generate enough to cover the devaluation of money over time, it would not be undertaken by rational management.

This same principle can be applied to cash management. Assets in cash form do not earn sufficient return to cover inflation. Thus, a firm should strive to convert as much of their asset base as possible into non-cash assets that can earn a return. This is especially true in periods of high inflation, where the real value of the cash can decrease significantly. When a business has more assets in cash than it needs to, this is considered to be inefficient cash management. In other words, the firm is not earning a return on that cash, but it could be.

Cash and other liquid assets belong to a class of assets known as working capital. The objective of any organization should be to keep working capital to the minimum required for the conduct of business, as a hedge against inflation. The same principle can be applied to current liabilities. If current assets should be minimized, current liabilities should be maximized.

The rationale behind this is that current liabilities represent obligations that must be met. In meeting those obligations, the firm will deplete its asset base. The longer the firm can delay payment - thereby retaining those assets - the longer the firm can earn a return on those assets. This equation is especially powerful during periods of high inflation. Liabilities, such as those for outstanding trade payable, are in nominal terms. Therefore, unless the firm is in a deflationary environment, the value of payables in real terms will diminish over time. Thus, the longer the firm delays payment, the less they will have to pay in real terms. During periods of high inflation, the amount paid in real terms can be significantly less. Therefore, all other factors being equal, a firm benefits from delaying payables as much as possible.