Improving Cash Management in the Small Firm: A Risk Adjusted Approach

ABSTRACT Some firms use some form of cash budgeting. However, the authors, in consulting with over 300 small businesses, have found that most small firms use little or none. Even those that do rarely attempt to adjust cash on hand for risk as measured by variability. The method shown here allows the user to adapt to his or her own level of desired risk, and also allows the use of type analysis. These analyses may be performed using almost any spreadsheet software and well known statistical manipulations. INTRODUCTION In the competitive world of today, an effective cash management program is an essential ingredient of business success. Cash is the lifeblood of a business. The inability to pay bills when due quickly leads to supplier suspicion. This, in turn causes the cash short firm to be placed on COD by suppliers which increases costs substantially, particularly when numerous small orders are needed. Often, small orders are all that can be obtained when suppliers perceive a firm to be in trouble. Bankers also get suspicious when their loan clients start to show signs of cash shortages. They are then prone to increase interest rates, deny further loans (maybe at the most critical point), and may call existing loans (Bennet, 1987). If cash shortages are allowed to continue indefinitely, then business failure is likely. This paper presents a financial planning and management system that aids the business operator in cash management. A method of adjusting the cash balance to account for risk associated with variability is discussed. The model also helps determine the minimum amount of cash required to meet a specific risk level, thus increasing the efficiency of asset utilization. THE IMPORTANCE OF CASH MANAGEMENT Bankers and financial analysts pay particular attention to the common financial ratios that involve cash and near cash items (Cardoza & Smith, 1983; Hopson, Ormsby & Hemingway, 1987; Morris, 1988). Gibson (1987) finds that certified financial analysts ranked quick ratio, current ratio, days' sales in inventory and cash ratio as the top four, in that order, from among fifteen commonly used liquidity ratios. Of these, days' sales in inventory is the only ratio that does not involve cash. Bankers also become suspicious of the need for multiple small loans that were unforeseen (Bennet, 1987; Hopson, Ormsby & Hemingway, 1987). These are the loans that are often brought about by increasing sales, which bring about correspondent increases in required cash, inventory and accounts receivable. This need for loans may be a sign of a healthy growing business, but, if unforecasted, portray exactly the opposite picture. Financial Management Models There are, undoubtedly, a number of financial planning tools available to small business managers. Some of them are quite sophisticated, expensive, and difficult to implement and use. Wilkinson (1987) identifies a number of problems with some models, and also indicates some of the features that should be incorporated to avoid those problems. This Model, In Wilkinson's terminology, what is proposed here is a model that is predictive in purpose, and involves both tactical planning and management control. It is relatively narrow in scope, and has a highly integrated structure. Its degree of aggregation is detailed, and could be operatively interactive if so desired. Its output could be hardcopy and/or softcopy for manager users, A number of spreadsheet software packages are commercially available that are capable of performing the required operations (Wilkinson, 1987, p. 7). The advent of computer spreadsheet software programs has made the problem of cash budgeting Jess onerous and perhaps more error free. They also have made possible the use of tools that incorporate more sophisticated techniques into the process. McEldowney and Ray (1985, p. 97) say that: Spreadsheet packages can generate the most valuable resource for the manager of a small business: time. …