Establishing minimum cash balance is not an easy task. If a company could sell all of its goods for cash and pay cash for all purchases on a daily basis, it could operate with a “zero” cash balance. This would be an ideal situation, because the lower the investment in cash (or any other asset), the higher the return on the entrepreneur’s investment.
It is not easy to figure out the minimum cash needed at any one time because of a second, conflicting objective in managing cash. Besides the desire for potential profitability, there is need for liquidity. Liquidity, in the form of a large cash balance (or, less certainly, a line of credit), provides the firm with the ability to handle unfavorable variances from projections. The conflict between these two objectives is another instance of an “eat well,sleep well” decision. A small cash balance means higher income. A large cash balance means less risk of financial embarrassment.
Forecasting minimum cash balance
Forecasting techniques aid in resolving the conflict by helping determine your company’s cash needs or surpluses and the likely variation in these estimates. The less accurate these forecasts, the higher the level of financial flexibility needed for a given level of “sleep well.”
One way of maintaining financial flexibility is to increase the cash balances above the minimum operating level shown by the forecasts. The forecasts cannot give an exact answer, however. The minimum cash balance decision is one that requires skilled managerial interpretation of the figures.
How to set up a minimum cash operating balance?
Another way of setting a minimum cash operating balance is to plan to maintain sufficient cash to cover disbursements during a period in which the company’s receipts might be interrupted for some reason. A company located in a region where weather can block mail for several days, but which must pay local suppliers and employees despite the weather, might typically hold an additional week’s cash disbursements in its balance as a buffer “cash inventory”,
If a company’s business requires investments of large sums on short notice in raw materials, management might elect to maintain many times-one week’s typical disbursements in the checking account or as very short, risk-less investments such as fixed Treasury bills. A company whose customers are unreliable in paying their bills will require more operating cash on the average than a company such as a retailer whose customers generally pay cash or use credit cards.
Factors affecting the level of minimum cash balance
Another factor affecting the level of the cash balance is a company’s banking relationships. The number of banks used and the types and quantity of bank services needed affect the size of the cash balances that must be carried with the banks. A company may keep more than one bank account for a variety of reasons:
- Widespread geographical plant locations
- Geographical location of customers
- Political and personal considerations
- Special accounts for payroll and other types of disbursements
- Control over funds
- Desire to have multiple suppliers of credit familiar with the company
Risk preference in establishing minimum cash balance
Finally, your own risk preferences are important. Some business owners prefer to arrange a loan and then draw down the full amount even though no immediate need requires the funds. The rationale is that it is easier to borrow when it is not necessary than when it is.
Other business owners elect to hold large cash balances even if the company has no debt because having cash makes fund management less stressful than not having cash.
Conversely, some business owners, particularly if the company is growing rapidly and cash-hungry, try actively to manage cash to a minimum to reduce the funding needed to support the aggressive growth.
Budgeting minimum cash balance
An analyst must take these dimensions into account when budgeting or forecasting the minimum-cash component. If the enterprise has shown a stable relationship between cash and sales or cash and cost of sales, it is an appropriate ratio to select for a minimum balance.
For new enterprises, rapidly growing ones, or companies in distress, a review of the company’s history may indicate the absolute minimum cash with which management has made do in the past. This amount can be used as the estimate for minimum future cash needs. A third approach is to set a minimum cash balance at one or two weeks’ cash disbursements. Lacking disbursement figures, one or two weeks’ cost of goods sold plus selling, general, and administrative expenses is a reasonable approximation of this estimate of minimum cash needed.