We’ve all heard the phrase “cash is king”, and we’ve even written a blog about it, but what does it really mean? In the business world, it means even a company with a healthy equity balance can get into trouble if their cash balance cannot support short term operations.
Here’s an example to help illustrate our point. The below table shows three scenarios. In each scenario, the company has $4,500 in current assets, $1,500 in current debt, and $7,000 in equity. The income statement remains unchanged in each scenario, however management in Company C is managing their working capital better, due to a larger chunk of their current assets coming from cash.
How Long Until We Get Paid?
One of the best ways to understand how to improve cash and working capital management is to monitor “Days to Cash.” Days to cash measures how long it takes for a company to convert resource inputs into cash flows.
The days to cash formula measures the amount of time from when inventory is first purchased and the company has a cash outlay (payment period), how long it is held (turnover period) and how long until the customers pay their receivable balance (collection period)
In other words, where the balance in accounts receivable is greater and cash is down (scenario A), the collection period is 49 days, as compared to the 21 days noted in scenario C. With the turnover period and payment period the same in each scenario, it is easy to see how the balances in receivables and cash impact the number of days until the entity has cash deposited in the bank.
Why Do Good Companies Run Out of Cash?
There are many reasons a company runs out of cash. Sometimes, it is due to poor collection policies or overspending on equipment and inventory. Other times, it is based on how the company is structured; entities like colleges and universities are able to collect tuition dollars before the students start school, padding the cash balance. Yet other entities run out of cash because of their successes. These companies may grow too fast and their cash gets tied up in inventory or receivables.
With low interest rates and payments being automated and billed over longer periods of time, it might seem like cash isn’t worth all that much on the balance sheet anymore. However, the above example doesn’t lie: to keep your business operating smoothly, you need to remember that cash is king. Our team is available to help you manage your money and keep cash flowing smoothly through your business.