Managing your cash balance is a crucial aspect of treasury management, as it affects your liquidity, profitability, and risk exposure. But how do you determine the optimal amount of cash to hold in your organization? In this article, we will explore some factors and methods that can help you find the right balance between cash inflows and outflows.
The main objectives of maintaining a cash balance are to meet your operational needs, to take advantage of investment opportunities, and to protect against uncertainties. You need enough cash to cover your expenses, such as payroll, suppliers, taxes, and debt payments. You also want to have some excess cash to invest in profitable projects, such as expanding your capacity, acquiring new assets, or entering new markets. Finally, you need to have a buffer to cope with unexpected events, such as fluctuations in demand, supply shocks, or emergencies.
I always recommend 3 x monthly opex requirements if possible! This figure allows for optimum trading ability if there is a business disruption event especially one that impacts your supply chain
However, holding too much cash can also have some costs and drawbacks. First, there is the opportunity cost of not investing the cash in higher-returning alternatives, such as stocks, bonds, or other assets. Second, there is the carrying cost of storing and managing the cash, such as bank fees, security, and administration. Third, there is the tax cost of the income generated by the cash, which may be subject to corporate or personal taxes. Fourth, there is the inflation risk of the cash losing its purchasing power over time.
These first three drawbacks of maintaining a strong cash position are really negligible. The last however is real and is manageable with proper business strategy and Cashflow Forecasting.
To find the optimal cash balance, you need to consider both the benefits and the costs of holding cash, and compare them with your cash flow projections. There are different methods and models that can help you do this, such as the Baumol model, the Miller-Orr model, or the cash budget. The Baumol model assumes that cash inflows and outflows are constant and predictable, and calculates the optimal cash balance based on the trade-off between transaction and holding costs. The Miller-Orr model accounts for the variability and uncertainty of cash flows, and sets upper and lower limits for the cash balance based on the trade-off between transaction and variance costs. The cash budget is a more detailed and flexible tool that forecasts your cash receipts and payments over a specific period, and identifies any surpluses or deficits that may require adjustments.
Once you have estimated your optimal cash balance using one or more of these methods, you can implement some strategies to optimize your cash management. For example, you can speed up your cash inflows by offering discounts or incentives for early payments, using electronic or online payment methods, or factoring your receivables. You can also slow down your cash outflows by negotiating longer payment terms with your suppliers, using credit cards or lines of credit, or leasing instead of buying equipment. You can also invest your excess cash in short-term and liquid instruments, such as money market funds, certificates of deposit, or treasury bills.
Finally, you need to monitor your cash balance regularly and adjust it as needed, depending on your changing circumstances and goals. You can use various indicators and ratios to measure your cash performance, such as the cash conversion cycle, the cash flow margin, the cash flow coverage, or the cash flow return on investment. You can also use dashboards and reports to track your cash position, cash flow, and cash forecast, and identify any gaps or deviations from your plan. You can also use scenario analysis and sensitivity analysis to test how your cash balance would react to different situations and assumptions, and prepare contingency plans accordingly.