Cash is king

The phrase “cash is king” is being used on many occasions in the finance world. Although I usually don’t like generalizations, I must say that this phrase is true in many circumstances. So, why is cash king?

Cash is needed to pay bills, compensate employees, and make purchases. Hence, a business needs enough cash as an asset for short-term operations. It also needs to ensure that there is sufficient stream of cash in-flow to cover all these expenditures in the future. Cash availability is an important metric to measure the overall fiscal health of a business.

In the accounting world a company can show a decent profit on its income statement. But that profit doesn’t necessarily mean that the company is financially healthy. When a sale is made, for example, the revenue is shown on the income statement, but it may be a while before the company receives cash for that sale. When this sale is made, a company increases its accounts receivables on its balance sheet, which in accounting terms increases also its net worth. However, the company could still be short on cash to keep its operations running. Despite its positive net worth the company could fail and be technically bankrupt.

There are several ways a company can improve its cash position. It can of course spend less, but this may have a negative effect on generating sales in the long-term. There are though three other ways to improve cash position by addressing three accounting elements: accounts receivable, accounts payable, and inventory.

As indicated above, accounts receivable is where the company records a sale to a customer until the customer pays for that sale. The cash is basically held captive in accounts receivable until the customer pays the bill. To improve its cash position, the company should collect money from the customer sooner than later.

Accounts payable is the equivalent of accounts receivable but the company is now on the paying side. Accounts payable is where the company records any money that it owes to its suppliers for purchases of materials, supplies, or services. Although these suppliers need to be paid at some point in time, the company has usually some time when to address this liability. The later these bills are paid the more cash is available to run the business.

Inventory is an accounting measure describing the financial value of raw materials and finished goods before they are sold to customers. Since cash can only be generated once a sales is made, inventory is another place where cash is held captive. Of course, there is a need for inventory to transfer raw materials into finished goods. It may also make financial sense to have enough finished goods inventory to react to sudden increases in demand. Hence, there is a need for the right balance between tying cash in inventory and quickly turning the inventory into a sale. While keeping this balance in mind, the sooner you can turn inventory into a sale the better.

The chart below illustrates cash flow and the interrelations between cash and accounts receivable, accounts payable, and inventory for a simple manufacturing business. This company buys raw material from a supplier, transforms it into finished goods, and sells them to a customer.

Once the company receives raw materials from the supplier, it starts manufacturing the products. At the same time it books the invoice from the supplier as accounts payable, but it still can use the cash intended to pay this invoice for other purposes for some time. Once the products are manufactured, the company sells them to the customer and awaits payment. The expected payment is booked as accounts receivable, but the corresponding cash is not available to spend yet until it is received from the customer. The inventory that is being processed consumes cash as well, which is not available for other purposes.

To increase its cash position – represented by the green areas in the chart – the company should maximize the accounts payable bubble by delaying payments to suppliers. It should minimize the accounts receivable bubble by collecting cash from customers as soon as possible, ideally immediately when the sale is made. And the company should minimize the inventory bubble by quickly turning inventory into a sale.