Managing Cash Week 17 Activity

Managing Cash

Week 17 Activity 1 Managing Cash

In business, one of the key necessities for all organizations to survive is cash. This is because the underlying amounts of liquidity an organization has, will determine their ability to be able to overcome various challenges. As the cash position of a business will provide a foundation for the entire organization. Even though this may sound obvious, the reality is that a variety of organizations have trouble effectively managing their cash reserves. At which point, the chances increase that an organization could faced missed opportunities, as they have no useful strategy for making their cash work most effectively for them. To overcome these different challenges, all businesses must be able to effectively manage their liquidity at all times. To determine how to achieve this objective we will be examining: why organizations hold their assets in cash, the costs of holding to much cash, the price for holding to little cash and how holding cash can be similar to possessing common stock. At which point, we will prepare a cash flow statement, will provide advice for improving liquidity at the musical instruments business and a solution to various working capital problems. Together, these different elements will provide the greatest insights, as to how an organization can effectively manage it cash position.

Why do organizations hold some of their assets in the form of cash?

An organization will hold some their assets in cash, because of a number of different situations that they could face as part of their daily operations. This includes: the ability to pay various expenses, the capacity to earn interest over the short-term (such as overnight), to protect against uncertainties that could occur in the business cycle / economy and to have enough liquidity to cover various expenses. (The Cash Flow Statement pp. 239 -- 256)

What are the costs of holding too much cash?

The cost of holding to much cash is that an organization could miss various opportunities in maintaining their growth rate. Where, the returns that they would be receiving from their cash would be much smaller in comparison with other investments. As result, those organizations that are holding to much cash will be unable to see their earnings grow, as they cannot use compounding to increase their underlying return. (The Cash Flow Statement pp. 239 -- 256)

What are the costs of having too little cash?

The costs of holding to little cash are: that a business could face various liquidity issues. Where, if the economic cycle changes dramatically or there are unexpected challenges, this could cause an organization to face a number of issues. The lack of cash could affect their ability to deal with various situations, as the low liquidity position, could mean that a business may be unable to remain open. (The Cash Flow Statement pp. 239 -- 256)

To what extent are the reasons for holding cash similar to those for holding stock?

The way that holding cash is similar to common stock, is through increasing the overall returns for an organization. As investors will seek out those companies that have the potential to see above average gains. The idea is that by investing in those corporations which offer above average growth rates, you can be able to increase your cash position, as the excess returns will cause this stance to improve. This is similar strategy that an organization will use with their cash. Where, they are will invest in those areas that can offer them above average returns, to increase their liquidity position as much as possible. A good example of this is when an organization will use laddering, to receive a greater return for various cash related investments. This is where they are spreading out the interest rates and maturity of the cash instrument. Where, the strategy is designed to increase the returns, that an organization is making, off of their cash investments. This is a similar approach used by stock investors, who are trying to prudently increase their returns. (Laddering 2010)

Prepare a cash flow statement for the business

Table 17.1 Cash flow statement for Musical Instruments Business first year of trading

Cash received from customers

1,850,000.00

Cash paid to suppliers

2,900,000.00

Cash expenses

Cash flows from operations

1,850,000.00

Bank interest paid

Net cash flow

-1,050,000.00

(Financial Statements pg. 133)

Advice on improving liquidity for Musical Instruments Business

The musical business that is being examined needs to reduce the underlying amount of expenses they are incurring. Where, they would immediately purchase £1.5 million worth of instruments. As they are using this strategy to help them over the long-term, yet it will negatively affect their liquidity position over the short-term. This is because the large purchase of instruments will eat away at their liquidity position. Given the fact that the company will not make any money until they sell an instrument; means that their cash could be tied up in the inventory that they purchased recently. Instead, what the organization should have done was to invest a smaller amount into the purchase of new instruments. This means, looking at the underlying amounts of cash and using only a certain percentage of it, to make additional inventory purchases. For example, a prudent strategy that the company could have utilized would be to: spend 25% of their cash on purchasing new inventory. This would allow the business to be able to invest less of their cash and to be able to maintain their liquidity position. As 25% of the £1.5 million spent, would be reduced to £462,500. This means, that the company's liquidity position would have remained fairly stable, as they would have £ 1,387,500 in cash. At which point, if some kind of uncertainty was to take place or a situation arises that the company would need its cash, they will be liquid enough to deal with whatever challenges they are facing.

The strengths of utilizing this strategy, is that you would be able to always maintain a solid liquidity position. The weaknesses, is that there could be down time or a shortage of certain instruments (especially if it is the holidays). The implications of this solution would be that the underlying amount of liquidity would improve vs. The company having a deficit. Table 17.2 summarizes how the business can improve its liquidity position.

Table 17.2 Advice on improving liquidity for Musical Instruments Business

Problem identification

Lack of Liquidity

Analysis (investigation)

NA

Conclusion to the analysis (results of the investigation)

The liquidity position needs to be improved dramatically. This is because, the £1.5 million that was invested in new inventory. At which point, the company's liquidity position would become negative

The solution, listed as a set of SMART recommendations

NA

Strengths and weaknesses of the recommendations

The strength is that liquidity position would improve, by allowing the company to take advantage of future opportunities. The weakness would be that the business could face an inventory backorder, from sudden changes in demand.

The implications of the solution, if implemented

This strategy would more than likely improve the underlying position dramatically. As it would intelligently utilize the cash to help the business, while maintaining a high enough inventory level that the profit margins can continue to increase.

Solution to a working capital problem in my organization