Cash is Cash, or NOT?

I can't tell you how many times I've heard the comment that "Cash is Cash". Most business owners would like to believe that cash is cash and is at their disposal to be used however they see fit because it makes managing cash much simpler. Well, it's not that simple. The principle that is vital to understand can be illustrated with an example. By the way, this is very important because not understanding could put your company in a working capital shortage position.

Instead of starting with a business, let's look at an employee who draws a "Take home" monthly salary of $5,000. His daughter comes home from school and informs the family that she must have a home computer in order to complete homework. Being a good parent, the employee buys a computer the next day and pays $800.

The employee has ignored his reoccurring current obligations like food, utilities, car payment, mortgage payment, etc. These current obligations or liabilities amount to $4,800 per month. He now will not have enough current cash to pay his short-term living expenses. The employee in fact has only $200 monthly of "Net Disposable Income" (NDI), or profit, money not already spoken for. Consequently, some of the current obligations will not be paid in the coming months because the employee spent $200 of his profit and $600 cash required for monthly living expenses.

Consequently, it will take this employee three months to make up this $600 cash deficit ($200 x 3 months) and get current on his monthly bills again. Alternatively, he dips into his savings (cash reserves). What happens if he does not have any savings?

Our employee above knew he had $200 each month of NDI and should have purchased the computer via a 12 month installment note. Doing so he would have been able to provide for living expenses, make the computer note payment and still have NDI left at the end of each month. What we have is a situation of cash available to buy the computer but not enough NDI.

Now let's see if we can jump over to an operating business and demonstrate this same principle. Operating cash, working capital, cash flow, liquidity all seem to be used to describe the same thing - cash. But what type of cash is the question. Most all transactions start with cash. For example, cash turns into inventory which is sold and becomes an account receivable which ultimately comes back in the form of cash. Some textbooks refer to this as the "Cash Circle or Cycle" which is diagramed below.

Just for reference, pull up one of your company's financial statements with the title at the top that reads "Balance Sheet". You should see all your assets, liabilities and of course the net worth/equity section. Closer examination will reveal that there are current assets and liabilities and long-term assets and liabilities. Long-term assets will likely be categorized as Fixed Assets.

It's no accident that the Fathers of Accounting decided to categorize assets and liabilities into current and long-term. You should ensure that your company's balance sheet accurately separates assets and liabilities into current and long-term. Current and Fixed Assets are probably already separated. Usually it's the liabilities that are grouped all together. Current liabilities are those that come due and are payable within 12 months.

Looking back to the cash circle above, you will note these accounts are in Current Assets. The theory being, all these accounts are used in your day to day transactions and are necessary to maintain your current monthly operations.

Let's return to the employee example. We accounted for $4,800 required monthly for living expenses. This leaves $200 per month of NDI which compares to "Net After Tax Income" (NATI) generated by a business. In other words, the employee can save or spend the $200. He cannot however, spend any of the $4,800 as he wishes. This amount is required for his living costs and must be available throughout the month for specific expenses. Likewise, a business can save or spend the after tax income just like the employee.

Each month the employee has $5,000 cash inflow which is current cash (asset) and pays $4,800 out in current obligations (liabilities) but gets to keep $200. The amount of cash to fund his cash circle required each month is $4,800. He is living below his means. We can now see a division of cash from the monthly cash flow into two separate Resources (or uses if you prefer). Like most businesses, the employee has only one "Source" of cash inflow i.e. his job but he has two cash "Resources" or uses. One resource required for monthly expenses ($4,800) and the other resource that can be used as and when he wishes ($200).

Simply stated, a resource for current obligations and a resource for other uses including longer term purchases. A smart employee would probably put the $200 into a savings account separate from his checking account and always know what he could spend outside of his required monthly cash circle. Most businesses will only have a checking account where all cash is deposited thus both "Resources" are in one account and no easy way to separate them.

Remember, NDI of the employee is comparable to a business's NATI. You may have reasoned by now that the source of long-term cash resource is profit. So, anytime you're purchasing an item outside your cash circle it should be limited to long-term cash resources or NATI. Probably it's safer to secure a term loan or lease to purchase items outside the cash circle.

The following is based on the assumption that your company is not sitting on a pile of unspoken for cash which continues to build. Never spend company cash to purchase fixed assets. Fixed Assets include but are not limited to - machinery and equipment, vehicles, leasehold improvements, real estate, software, etc. While these items may be required for the operation, the fact remains they are long-term assets (outside the cash circle) and should be paid for from long-term cash resources i.e. the stream of cash from your monthly profit.

If your company has a revolving line of credit, never, never let me repeat never purchase a fixed asset with funds from a line of credit. Also, never fund operating losses from a line of credit. If you do, your company will be in the same situation as the employee who purchased the computer with cash from inside his cash circle. The time to replenish your cash circle will depend on how much you spent and the level of profits.

Let's demonstrate with another diagram.

The above Pie Graph represents your cash circle of say $500,000. You decide to purchase a new machine costing $100,000. You look at your bank account balance and you've got $200,000 so why not just pay for the machine? And you do. Now there is a slice missing that represents the $100,000 you spent for the new machine. Obviously, the $100,000 was too much cash out of the circle because you now have a gap in your cash circle, one that will not be filled for some time.

Cash is where you will see the adverse effects first of spending the wrong cash resource for something outside the cash circle. Next you will see the effects in your inventory, i.e. orders will not be filled as quickly as before. And you will not be able to keep as current on payables to suppliers because of a shortage of cash.

Your cash circle will follow your business activity. If your company is growing then the circle will expand and require more cash. Likewise, if your company is on a downward trend the circle with become smaller and require less cash.

You can calculate how much cash is in your cash circle at any time by simply adding Cash on hand plus Inventory plus Accounts Receivable. That number represents your investment in your cash circle. For most companies this will be their largest investment.

You can use Business Loan Scores to calculate the long-term resource portion of your cash flow and score your company's ability to obtain a loan to make capital purchases and/or a revolving line of credit to increase working capital. In today's economic climate I suggest you apply for a line of credit if you don't have one. The line of credit will come in handy when payments from your customers slow and you need to pay suppliers more timely.

I can think of nothing more important than constantly monitoring your cash circle. When I am advising a client, I will frequently (weekly) evaluate their cash circle levels and ratios. Below are some tips to help you do the same.

Current Ratio: Total Current Assets divided by Total Current Liabilities
Should be 1.25 or greater
Quick Ratio: Cash + Accounts Receivables divided by Total Current Liabilities
Should be .5 or greater
Sales to Cash Ratio: Total Annual Sales divided by Cash on Hand
Should be less than 12

(Hint: Sales to Cash ratio can be calculated each month just ensure you have added the most recent 12 months of sales each time you calculate. Do not wait until the end of the year.)

This principle "All Cash is NOT Disposable Cash" is a principle with which to manage your business more efficiently and maintain a strong financial position.

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