Putting Cash to WorkLocate and post a recent news story from The Wall Street Journal or other reputable source about?a publicly-traded company that has been criticized for its cash manageme

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JWI 531: Financial Management II

Week Seven Lecture Notes

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IS CASH REALLY KING? What It Means Cash and investment management refers to the practices of holding and moving cash within the organization in order to ensure sufficient liquidity for the day-to-day operation of the business, as well as the investment in short-term assets to generate returns. While the Statement of Cash Flows presents a summary of the cash that moved in or out of the organization from operating, financing, or investing activities, it does not provide a detailed view into the weekly or monthly cash management activities. Why It Matters

• Short-term and medium-term cash flow forecasts must accurately describe how much money is coming into the company and how much money is going out. This way, allocation decisions can be made to ensure sufficient funds are available to meet expenses.

• Consolidating cash accounts from multiple business units creates a clearer picture of cash

reserves.

• It enables managers to improve how cash is being used to operate the business and how idle cash can be invested to generate short-term returns.

“The main thing to know about cash flow is that it just does not lie. It tells you in raw, hard numbers how much money went out, how much came in and how

much you have.’

Jack Welch

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JWI 531 (1202) Page 3 of 9

THE CHALLENGE AND OPPORTUNITY FOR MANAGERS

Cash is the lifeblood of an organization.

• At the extreme, companies go bankrupt, not because they’re unprofitable, but because they run out of cash to pay their bills.

• Great ideas and opportunities are often missed because of insufficient access to cash. • Idle cash is a symptom of poor stewardship and an impediment to growth.

These are just some of the reasons you will often hear the expression, “cash is king.” Every business must have sufficient cash on hand to manage operating expenses, but one of the challenges for financial managers and CFOs is to deploy cash management practices that balance liquidity, transparency, and return. That is, they must ensure there are sufficient cash reserves in place so that bills can be paid on time, and so they have clear visibility into the cash balances of different business units. But they must also find ways to do this which maximize the returns on those cash balances without incurring undue risk by investing it in vehicles that have excessive fluctuations in value. This is especially challenging in times of low interest rates, which can be great when businesses want to borrow money, but devastating to cash reserves. In many ways, this balancing act is no different than what goes on in managing the operating budget of your household. Money comes in from earnings and goes out to pay bills. In between those two events, some of that money will be moved among various accounts for different purposes. Most financial advisors recommend that their clients have at least two months of salary saved up for emergencies. While it may be tempting to put all your cash into equities (perhaps a broad index fund) to maximize return, you run the risk of being forced to tap into those funds at a time when the market is undergoing a downturn, thus realizing a loss on your investment. Furthermore, businesses are set up to make money for their owners through developing and selling their products. Storing up a lot of cash may make for a great balance sheet, but if that cash is not being put to work in growing the business, your investors are going to start getting restless for bigger returns. After all, if they just wanted to be sitting on a bunch of cash, they could do that without investing in your business. Understanding how cash is managed is critical to building a financially healthy and stable organization. The topics we cover this week will provide a fascinating look into practices that most non-financial managers never think about. Even if you have no direct responsibilities in this area, understanding what’s going on behind the scenes can help you operate your business more efficiently, and it can make you a better investor.

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JWI 531 (1202) Page 4 of 9

YOUR STARTING POINT

1. How well do you understand the terms used to discuss cash management strategies?

2. If someone asked you how cash is held and moved in your organization, what would you say?

3. Why is it important to have cash reserves that can be quickly accessed?

4. What are the downsides of holding too much cash?

5. Could you explain what data about cash management is, and is not, included in the Statement of Cash Flows?

6. What can you learn about the financial health of investment opportunities by looking at how companies handle their cash?

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JWI 531 (1202) Page 5 of 9

MANAGING CASH AND INVESTMENTS

How Cash Flows Cash flows are objective. Either they occur or they don’t, and that's why many people like to look at the Cash Flow Statement – because of its objectivity. In fact, all of the reasons that cash flows into or out of an organization can be collected into three basic categories:

• The first is operating activities. This is most commonly where cash would move into or out of an organization. Cash collected from customers for sales, cash paid to employees for their time, cash paid for operating expenses like rent and promotional expenses such as advertising are all examples of operating cash flows.

• The second category is called financing cash flows. From the organization's point of view, a financing cash flow is a transaction that has to do with raising or returning capital. For example, cash coming in from a bank loan or cash coming in from the sale of newly issued shares are financing cash flows.

• The third category of cash flow is investing cash flows. These are cash flows associated with the acquisition or divestment of fixed assets such as buildings, land, and equipment.

All of the reasons why cash could flow into and out of an organization are captured in these three categories. Understanding the pattern and direction of cash flows is an excellent way to test if an organization is really following its stated strategy. What Is Cash and Investment Management? In his chapters on Cash Management (10) and Investment Management (11), Bragg outlines the goals and options that CFOs have in ensuring that their company’s cash is being used to strengthen the organization’s financial health. The most important element of these is liquidity. In most organizations, responsibility for these decisions falls on the CFO. However, ensuring that cash flow forecasts are accurate and ensuring that there are enough cash reserves in place for the company to pay its bills on time usually requires input from managers to minimize variances. This is important for companies of any size, but it is especially important for startups and smaller organizations for whom “coming up short” could potentially topple the business. Bragg explains:

“The management of cash begins with a cash forecast. The forecast is designed to give the CFO insights into the state of cash inflows and outflows over the next few weeks and months. In addition, it is useful to have a system in place for collecting and concentrating incoming cash as quickly as possible, so that it can be made available for operational and investment purposes. The ability to forecast and concentrate cash is central to a system of cash management.”

The CFO Guidebook, p. 195

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“The short-term cash forecast is based on a detailed accumulation of information from a variety of sources within the company. The bulk of this information comes from the accounts receivable, accounts payable, and payroll records. Since this forecast is based on detailed itemizations of cash inflows and outflows, it is sometimes called the receipts and disbursements method.”

The CFO Guidebook, p. 196 Two broad factors impact the accuracy of cash forecasts: (a) time frame – as the forecast window gets longer, the certainty of cash forecasts are subject to increasing variance, and (b) the quantity of key line items monitored to make the forecast. An illustration of the latter is presented on pp. 197-198. In practical terms, more is not always better. As Bragg demonstrates through his example, “The format is designed with the goal of giving sufficient visibility into cash flows to reveal the causes of unusual cash shortfalls or overages, without burying the reader in an excessive amount of detail.” (p. 199) Liquidity Matters…Every Day! Managing cash effectively requires financial leaders to get into the weeds to understand what’s really going on with monthly – or even weekly – cash flow events. A particularly large sale or payment can have a significant impact on cash balances. It is, therefore, not appropriate to try to use averages, especially for accounts receivable.

“If a CFO were to rely upon an averages-based cash forecast, there would be a high risk of routinely having cash shortfalls and overages. After all, the CFO is responsible for ensuring liquidity every day, not just on average. Thus, we strongly recommend against the use of averages when forecasting the larger items in a short-term cash forecast.”

The CFO Guidebook, p. 201

If you are new to the organization and still learning the ropes of how cash flows, don’t give in to the temptation to rely on rolled-up data. Work with managers and frontline operators. Dig in and ask questions. Make sure you understand what is driving key line items. As you become more familiar with the operation of the business, you’ll learn which items are most critical to the accuracy of your forecast. You can plan for these to ensure that your company’s liquidity is never at risk. Cash Concentration For organizations that have cash flowing in and out through a number of different business units, there are often advantages to bringing cash together into a common pile. This process, known as cash concentration, can have three benefits:

• Greater visibility into the entire cash situation across all business units • Increased liquidity so that more cash can be accessed to pay bills • Reduction of banking fees and maximization of earned interest

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Concentrating cash from different businesses may or may not be an important part of your finance strategy. It depends on a number of factors, including the legal structure of the company, geographical and currency considerations, as well as how cash flows into and out of the various business units. But whether or not cash concentration practices impact you, you should review Bragg’s treatment of the topic so you understand the benefits, challenges, and options. Specifically, you should acquaint yourself with the impact that bank fees and interest rates can have on cash held in one place versus multiple places (pp. 204-205). Additionally, you should look at the options for cash sweeping – bringing cash from multiple accounts into a central account (pp. 205-210) and notional pooling – the practice by which the bank “combines the ending balances in all of a company’s accounts to arrive at an aggregate net balance.” (See p. 211 as well as the comparison chart on p. 215) As with other topics we have explored in this course, improving cash management is never one-and-done. It is best to approach it as an opportunity to create a more open dialogue between financial leaders and business operators. Bragg advises,

“It is not sufficient to reach this level of success and then move on to other projects. Instead, build review systems that constantly monitor forecasts to see if accuracy levels start to decline, and use this information to correct the forecasting model at once. This high level of watchfulness is needed in every company, since the alteration of company systems that is triggered by new lines of business, new software, acquisitions, and so forth will eventually alter the inputs to the cash forecast, making its results less reliable.”

The CFO Guidebook, p. 214

Investment Options Bragg presents a summary of key terms and cash investment options available to companies. He explains the pros and cons of a number of different vehicles, including Certificates of Deposit, Money Market Funds, Bonds, and Treasury Bills. While these may sound somewhat dull to investors who focus on equities, he reminds us that, “…cash management is primarily about keeping cash reserves available for operational use; it is not about maximizing return on investment.” (p. 216) Thus, any investment being considered must meet the following objectives:

1. Protect the cash – business must be able to get their investment back. 2. Ready conversion to cash – liquidating the investment must be fast and straightforward. 3. Earn a return – only after the first two have been satisfied should maximizing the return on

investment be considered. Bragg emphasizes the importance of having a clear investment policy approved by the board. He presents an example of what this might looks like on page 218. In closing, he reminds us:

“We must make it clear that the CFO should be exceedingly risk averse when investing company cash. All but the largest and wealthiest corporations will be harmed by an investment loss, so do not even attempt to gain outsized returns on investment when the accompanying risk level is too high.”

The CFO Guidebook, p. 217

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JWI 531 (1202) Page 8 of 9

SUCCEEDING BEYOND THE COURSE

As you read the materials and participate in class activities, stay focused on the key learning outcomes for the week and how they can be applied to your job.

• Examine the role of cash management strategies to improve forecasts and cash flows Review how your organization’s strategy and operating budgets align to determine what this means for cash flows and cash management. Have conversations to ensure that business operators and financial managers understand the most important sources of inflows and outflows of cash on a weekly and monthly basis. Look for opportunities to minimize variances, such as having a consistent payment calendar for your vendors and consistent billing for your customers. Encourage managers to communicate large or unusual inflows or outflows that are expected before they occur, so the finance team can be prepared.

• Explore best practices and tools of cash management, including cash sweeping and

notional pooling Depending on your role, you may have no responsibility for managing cash from different operating units of your business. Even if that’s the case, consider scheduling time with a member of your finance team to discuss how your business manages cash. Share what you have been learning in this course and compare this to what is done in your company. Financial strategy practices often make a lot more sense when you see how they are actually being applied in your own workplace.

• Identify the advantages and disadvantages of common investment options

Investing cash reserves for a business follows largely the same principles as investing your own personal cash. It is a balancing act among risk, return, and liquidity. Low-risk options like T-bills may pay less, but are extremely secure and liquid. Think about the specific cash needs your business has. For example, if your company does business in foreign markets or pays for services in foreign currencies, there may be advantages to holding cash reserves in other currencies to protect against fluctuations. As an investor, or even an active trader, you will want to keep some cash on hand to take advantage of new opportunities, such as a drop in price of a stock you have been looking to add to your portfolio. Just make sure it is held in a vehicle that pays the best return while offering you the security and liquidity you need.

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JWI 531 (1202) Page 9 of 9

ACTION PLAN To apply what I have learned this week in my course to my job, I will…

Action Item(s) Resources and Tools Needed (from this course and in my workplace) Timeline and Milestones Success Metrics