Understanding effective cash management

This article looksat cash manage-ment as a tool to

maintain the companyin the most economi-cal, efficient, andeffective manner pos-sible. In this regard,the company mustkeep in mind thoseoperational areas that affectcash in and out. With theseprinciples in mind, operationscan be analyzed to identifyareas for improvement in whichbest practices can be imple-mented that maximize cashinflow and minimize cash out-flow.

Although the primary focusof ongoing cash managementand continual operational analy-sis is on the manner in whichcash is used by the organization,considering the sources and usesof cash and the policies and pro-cedures used to deal with overand under cash conditions, thereare other operational areas thatwill need to be addressed as welldue to their direct impact oncash flow, including those listedin Exhibit 1.

There are many other opera-tional areas and concerns that

could be listed in Exhibit 1.Those listed are only meant asexamples of areas that should beconsidered in the company’smanagement of cash. Effectivecash management may result inthe analysis of many of the com-pany’s major operations, as cashaffects every function and activi-ty. To ensure that the companyoperates with effective cashmanagement procedures, it mustunderstand that every dollarexpended and every dollar col-lected must be evaluated as to itsappropriateness to the company’splans and operations.

Benjamin Franklin oncesaid, “There are three faithfulfriends—an old wife, an old dog,and ready money.” The first twoshall pass without comment, butthe third assuredly is as relevanttoday as it was in Franklin’stime.

MANAGING CASHFOR RESULTS

Profit can bethought of as an emer-gency number createdby accountants. Hav-ing enough cash allowscompany managementto concentrate ongrowth, finding new

businesses, acquiring new cus-tomers, locating new businesspartners, developing new prod-ucts, installing new processes,and so on. Not having enoughcash forces the company to fix-ate on getting more, sometimesto the exclusion of growth anddevelopment.

An early step in successfulcash management is for theorganization to clearly define itsdesired criteria for results andsuccess as related to such factorsas reasons for existence, basicbusiness principles, mental mod-els, belief systems, performancedrivers, and so on. This thinkingcan result in probing deeper intothe inner workings of the organi-zation. These organizational crite-ria typically relate to the companyas an entity as well as to its majorfunctions. An example of such an

To really be effective at cash management, youmust look at many different operational areas inyour company. The author presents a valuablehow-to guide so you can understand and mastereffective cash management techniques.

© 2005 Wiley Periodicals, Inc.

Rob Reider

Understanding Effective CashManagement

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7© 2005 Wiley Periodicals, Inc.Published online in Wiley InterScience (www.interscience.wiley.com). DOI 10.1002/jcaf.20161

8 The Journal of Corporate Accounting & Finance


What Else Affects Cash Flow

Here are some areas that affect cash flow—and what questions you can ask to find and fix problems.

1. Sales of Products or Services• Are sales made to quality customers with the right products at the right time?• Does each sale make a contribution to profits?• Are all costs compared to the sale such as product costs (direct material and labor), assignment of prod-

uct-related activity costs (e.g., manufacturing processes, quality control, shipping, receiving, and so on),functional costs (e.g., purchasing, accounts payable, billing, accounts receivable, and so on), and customercosts (e.g., marketing, selling, support services, customer service, and so on)?

• Do sales relate to an agreed-upon sales forecast? Is the company selling the right products to the rightcustomers?

• Do sales integrate with an effective production scheduling and control system?

2. Manufacturing or Production of Services• Are sales orders entered into an effective production control system that ensures that all sales orders are

entered into production in a timely manner to ensure on-time, quality deliveries?• Is work-in-process kept to a minimum so that only real customer orders are being worked on rather than

building up finished-goods inventory?• Are the most efficient and economical production methods used to ensure that the cost of the product is

kept to its realizable minimum?• Are direct materials and labor used most efficiently so that waste, reworks, and rejects are kept to a mini-

mum?• Are nondirect labor (and material) costs such as quality control, supervision and management, repairs and

maintenance, materials handling, and so on kept to a minimum?

3. Billing, Accounts Receivable, and Collections• Are bills sent out in a timely manner—at the time of shipment or before?• Are accounts receivable processing procedures the most efficient and economical?• Is the cost of billing, accounts receivable processing, and collection efforts more costly than the amount of

the receivable or the net profit on the sale?• Is the number and amount of accounts receivable continually analyzed for minimization?• Are any customers paying directly or through electronic funds transfer at the time of shipping or delivery?• Are bills and accounts receivable in amounts exceeding the cost of processing excluded from the

system?• Has consideration been given to reducing or eliminating these functions?

4. Inventory—Raw Materials and Finished Goods• Are raw material and finished-goods inventories kept to a minimum?• Are raw materials delivered into production on a just-in-time basis?• Are finished goods completed in production just in time for customer delivery?• Is the company working toward getting out of these inventory businesses?

(continued)

Exhibit 1

organizational results criteriastructure is outlined in Exhibit 2.

EFFECTIVE CASH FLOWBASICS

What Is Cash Flow?

Effective cash managementis essential to the success andsurvival of the business. It maybe even more important thanproducing goods or services orgenerating a sale. Most business-es can lose a sale or a customerand still continue operations.However, miscalculate the avail-ability of cash when needed (forexample, for payroll or taxes or acritical vendor) and the companymay very suddenly be out ofbusiness. Cash flow management

helps to avoid such operationalcrises by applying some basicprinciples to the business.

The company needs cash topay its bills—business expenses(i.e., service or manufacturingcosts, selling expenses, generaland administrative costs, and soon)—and to pay off scheduledliabilities (e.g., loans, accountspayable, taxes, etc.) on time.Cash generally comes from foursources:

1. Sale of equity—in the formof company stock or owner-ship of the business;

2. Borrowing—from a varietyof sources such as friendsand relatives, customers,vendors, employees, andfinancial institutions;

3. Conversion of assets tocash—sale of idle orunneeded facilities or equip-ment, reduction of excessinventory, or collection ofaccounts receivable; and

4. Reinvested profits—thoseresulting from real cash col-lections, not just fromrecorded sales that may ormay not be collected.

Keep in mind that everybusiness has to be continually inthe cash conversion business.The process starts with a cashinfusion, produces products orservices for customers, sells anddelivers the product or service,bills, collects payment, and addsthe resulting cash to the businesscoffers. A successful business

November/December 2005 9


What Else Affects Cash Flow (continued)

5. Purchasing, Accounts Payable, and Payments• Are all items that are less than the cost of purchasing excluded from the purchasing system—with an effi-

cient system used for these items?• Are all repetitive high-volume and high-cost items (e.g., raw materials and manufacturing supplies) negotiat-

ed by purchasing with vendors as to price, quality, and timeliness?• Does the production system automatically order repetitive items as an integrated part of the production con-

trol system?• Has consideration been given to reduce these functions for low- and high-ticket items, leading toward the

possible elimination of these functions?• Does the company consider paying any vendors on a shipment or delivery basis as part of its vendor negoti-

ation procedures?

6. Other Costs and Expenses—General, Administrative, and Selling• Are all other costs and expenses kept to a minimum? Remember, an unnecessary dollar not spent is a dollar

that goes directly to the bottom line.• Are selling costs directed toward customer service and strategic plans rather than maximizing salespeople’s

compensation?• Is there a system in effect that recognizes and rewards the reduction of expenses rather than the rewarding

of budget increases?• Are all non-value-added functions (e.g., management and supervision, office processing, paperwork, and so

on) evaluated as to reduction and elimination?

Exhibit 1



Define Your Criteria for Success

An early step in successful cash management is for the company to clearly define its criteria for success. Here’s an exam-ple of such an organizational results criteria structure.

Organizationwide Criteria• Operate all activities in the most economical, efficient, and effective manner possible.• Provide the highest-quality products to our customers at the least possible cost.• Satisfy our customers so that they will continue to use the company’s products and refer the company to others.• Convert the cash invested in the business as quickly as possible so that the resultant cash in exceeds the cash out to

the greatest extent possible.• Achieve desired results using the most efficient methods so that the company can optimize the use of limited

resources.• Maximize net profits without sacrificing quality of operations, customer service, or cash requirements.Sales Function• Make sales to the right customers that can be collected profitably.• Develop realistic sales forecasts that result in a present or future real customer order.• Sell those products as determined by management to the right customers, at the right time, in the right quantities.• Ensure that actual customer sales correlate directly with management’s long- and short-term plans.• Assure that sales efforts and corresponding compensation systems reinforce the goals of the company.• Integrate customer sales with other functions of the company, such as manufacturing, engineering, accounting, pur-

chasing, and so on.Manufacturing• Operate in the most efficient manner with the most economical costs.• Integrate manufacturing processes with sales efforts and customer requirements.• Manufacture in the most timely manner considering processes such as customer order entry, timely throughput, and

customer delivery.• Increase productivity of all manufacturing operations on an ongoing basis.• Eliminate, reduce, or improve all facets of the manufacturing operation including activities such as receiving, inventory

control, production control, storeroom operations, quality control, supervision and management, packing and shipping,maintenance, and so on.

• Minimize the amount of resources such as personnel, facilities, and equipment that are allocated to the manufacturingprocess.

Personnel• Provide only those personnel functions that are absolutely required as value-added activities.• Maintain the levels of personnel at the minimum required to achieve results in each functional area.• Provide personnel functions such as hiring, training, evaluation, and firing in the most efficient and economical manner

possible.• Develop an organizational structure that organizes each function in the most efficient manner for their purposes.• Minimize the hiring of new employees by such methods as cross training and interdepartmental transfers and other

best practices.• Implement compensation systems that provide for effective employee motivation and the achievement of company

goals.(continued)

Exhibit 2

collects more cash from cus-tomers than it expends for pro-viding and servicing its productsand services. The positive differ-ence is called profit and a nega-tive difference is called loss. Thecompany is not only concernedwith managing its cash in a posi-tive manner but also in closingthe gap in terms of time betweencash infusion and the ultimatecollection of cash. The cash gapcan be considered the number ofdays between when it pays formaterials and services and whenit receives payment for the saleof the product or service. Thelonger this gap, the more timethe company is out of pocket forcash. The company must havecash generated from other salesto take up this cash slack. If thisis not possible, the companymust finance the difference in

the cash flow. Thus, the unavail-ability of cash can become quiteexpensive to the company interms of the cost of borrowing aswell as the inability to operatemost economically, efficiently,and effectively.

Every organization is contin-uously in the cash expansion andconversion business; whateverbusiness the company is in startswith a cash infusion and eventu-ally ends in a cash liquidation. Ifthe company is successful, end-ing cash will exceed starting cashby more than enough to cover thetime value of the cashinfusion(s). The company cannotbe in the business of selling tononpaying customers or sellingproducts that generate less cashthan their costs. Furthermore,investing in accounts receivable,sales backlog, or inventory

should be avoided since thesecannot be spent or reinvesteduntil they are converted back intocash. Inadequate cash is often theprincipal limiting factor in thegrowth of the business, and thecompany’s goal should be toaccelerate the cash conversionprocess as much as possible.

Effective cash managementmaximizes cash generation forthe business. This means, ineffect, generating positive cashflow by applying effective tech-niques for collecting cash due tothe company, expending no morecash than necessary, and delay-ing (within limits) the paymentof cash due others. For the busi-ness to survive, it must havecash when it needs it. In addi-tion, a positive cash buffer pro-vides a safety net against unfore-seen business crises,



Define Your Criteria for Success (continued)

Purchasing• Purchase only those items where economies can be gained through a system of central purchasing.• Implement direct-purchase systems for those items that the purchasing function does not need to process, such as

low-dollar purchases and repetitive purchases.• Simplify systems so that the cost of purchasing is the lowest possible.• Effectively negotiate with vendors so that the company obtains the right materials at the right time at the right quality at

the right price.• Maintain a vendor analysis system so that vendor performance can be objectively evaluated.• Develop effective computerized techniques for economic processing, adequate controls, and reliability.Accounting• Analyze the necessity of each of the accounting functions and related activities, such as accounts receivable, accounts

payable, payroll, budgeting, and general ledger.• Operate each of the accounting functions in the most economical manner.• Implement effective procedures that result in the accounting functions becoming more analytical than mechanical.• Develop computerized procedures that integrate accounting purposes with operating requirements.• Create reporting systems that provide management with the necessary operating data and indicators that can be gener-

ated from accounting data.• Eliminate or reduce all unnecessary accounting operations that provide no value-added incentives.

Exhibit 2

emergencies, or managementerrors, and allows the companyto take advantage of opportuni-ties that may arise. Sufficientcash availability is also neces-sary for the business to grow andsurvive. Businesses typically failnot from lack of growth or lackof profitability, but from lack ofcash to pay the bills.

Also keep in mind that anoverinvestment in cash canimpose opportunity costs on thebusiness by loss of earnings onthat “excess” cash that would beavailable from investment inprofitable alternative opportuni-ties. However, excess cash doesnot normally lead to seriousbusiness problems, while insuffi-cient cash is always a problem.Effective cash managementallows the company to control its

cash and manage its businesseconomically, efficiently, andeffectively. In this way, the com-pany can reduce business disrup-tions, operate in a smooth andefficient manner, and provide forits ongoing growth and prof-itability. A schematic of the flowof funds in a business is shownin Exhibit 3.

The Cash Flow Process

Any business—manufactur-ing, service, financial, not-for-profit, government, and so on—begins with an infusion of cash.The fundamental operating cashflow process within the businessthen operates in a continuousloop of short-term asset transfor-mation as shown in the cash gen-eration cycle (see Exhibit 4).

A business starts withcash—the owner’s investmentand usually some borrowedfunds. The purchase of goods orservices, together with the man-ufacturing process or serviceprovision, transforms the cashinto inventory or services to bedelivered. As the goods or ser-vices are provided to the cus-tomer, they are converted toaccounts receivable or cashreceipts. The collection processthen transforms the accountsreceivable back into cash. If thebusiness process works properly,the cash received is greater thanthe cash laid out, and the result-ing excess (i.e., profit) providesthe business with additionalfunds to reinvest and grow. Theprocess then needs to repeatitself in an ever-increasing con-tinuous cycle. A major planningstep must always be to have suf-ficient cash available to allowthis series of activities to contin-ue unabated.

The schematic in Exhibit 4is, of course, a simplistic repre-sentation of a typical cash gener-ation process. Factors such asaccounts payable, outsidefinancing, asset conversion, andprofits from operations typicallyincrease the amount of cashresources available. However,accounts receivable increases,inventory investment, debtrepayments, dividends, and oper-ating losses decrease the level ofcash. In addition, most business-es require periodic purchases offixed assets—property, plant,and equipment—in order tomaintain or expand their busi-ness activities. These are not partof the cash generation cycle butdo require an outlay of cash,often quite significant.

In reality, the cash flowprocess does not operate simplyor smoothly but is subject tonumerous disruptions. Changes



Exhibit 3

Flow of Funds in a Business

in the level of inventory retard orincrease the flow of cash, as dochanges in the level of accountsreceivable and accounts payable.Payables are free short-termloans from vendors or suppliersthat represent a source of cashfor the business. Inventory andaccounts receivable, however, areidle assets reducing cash avail-ability until they can be convert-ed into sales and collected.Chronically high levels of inven-tory or accounts receivable caneasily threaten the survival of thebusiness. While cash itself con-tributes only minimally (throughpossible interest earnings) toprofitability, it does make possi-ble the acquisition of the goodsand/or services that create prof-itability.

The problems associatedwith too little cash are obvious.Too little cash means problemsof survival, while too much cashcan result in lost opportunitiesand inefficient utilization of lim-ited resources. Cash flow man-agement is a continual effort tosmooth out fluctuations andfocus on the Goldilocks CashManagement Principle—“not toomuch, not too little, but just theright amount.” There is no for-mula to make this determination,but there are several factors thatneed to be considered:

• There needs to be enoughcash to pay the companybills.

• There needs to be enoughcash to meet any require-

ments such as compensatingbalances, minimum cash bal-ances to cover servicecharges, or loan covenants.

• There needs to be enoughcash to handle unanticipatedopportunities or emergen-cies.

• There needs to be enoughcash to provide the ownersof the company, companymanagement, and/or the cashmanager with sufficientsleep insurance—that is, toprovide a sufficient marginto meet the safety needs ofthe business and its manage-ment personnel.

The first two of these arerelatively easy to calculate, butthe latter two are totally subjec-tive and will have to be deter-mined by each company.

Objectives of CashManagement

Cash management focuseson making the asset transforma-tion process of the businesswork smoothly. To accomplishthis, the company needs to beaware of the objectives of cashmanagement (see Exhibit 5).

Effective cash managementis necessary due to a lack of syn-chronization between incomingand outgoing cash flows, a lackof reliable forecastability of cashinflow amounts and timing, andcosts of holding cash balances orborrowing to cover cash short-falls. What the cash managementsystem should be designed to dois shorten the cash generationcycle by effectively managingthe assets, liabilities, revenues,and costs of the business.

Cash flow can be maxi-mized, borrowing minimized,and return on assets enhanced byfollowing the steps listed inExhibit 6.



Exhibit 4

Cash Generation Cycle



The Objectives of Cash Management

• Operate all activities in the most economical, efficient, and effective manner possible.• Control and track cash flows.• Optimize sources and uses of cash.• Maximize revenues and minimize expenditures.• Collect for sales as quickly as possible.• Expend cash only where necessary (i.e., value-added functions and activities only).• Pay creditors no sooner than necessary, and minimize the costs associated with vendor purchases and payments.• Provide for adequate external sources of funding.• Properly manage external short-term borrowing and/or investment activities.• Effectively utilize any excess differential cash generated.• Keep the cash conversion gap at a minimum.

Exhibit 5

Maximizing Cash Flow

You can maximize cash flow, minimize borrowing, and enhance return on assets by:

• selling profitable products or services to quality customers who pay on time;• speeding collection of accounts receivable, or collecting in advance of or at the time of delivery of the product or ser-

vice;• getting material and purchased parts inventory into production and out the door as quickly as possible, or getting out of

that inventory business entirely by letting the suppliers carry the inventory;• reducing or eliminating finished-goods inventory by shipping immediately from production to the customer;• maintaining work-in-process inventory at minimum levels by effective production scheduling and control techniques

that ensure maximization of real customer orders into production, minimizing production time, eliminating rework andrejects, and minimizing production costs;

• taking maximum advantage of accounts payable and other interest-free loans by not paying sooner than required; • reducing expenditures whenever possible;• avoiding accounts payable entirely where payable costs exceed the amount of the invoice or where vendor price reduc-

tions for fast payment exceed the cost of processing the payments;• operating the business efficiently in the use of fixed assets, or increasing results with the use of fewer resources;• operating the business in the most economical and efficient methods by keeping costs and non-value-added functions

and activities to a minimum;• diligent management of the cash assets of the business by minimizing investment in property, plant, and equipment;• operating with the least number of personnel possible;• incurring costs and expenses for only necessary value-added functions and activities; and• maximizing sales to real quality customers, which can be produced and delivered at real cash profits.

Exhibit 6

Profitability versus Liquidity

We have all heard the outcry,“If I’m making so much money,how come I don’t have anycash?” This exemplifies the dif-ference between profitability andliquidity. Profitability has to dowith making an adequate returnon the capital and assets investedin the business. Liquidity relatesto having an adequate cash flowthat allows the company to makenecessary payments and ensurethe continuity of operations.Management, and investors, havebecome somewhat obsessed with

profitability in terms of return oninvestment (ROI) (e.g., return onassets [ROA] or return on equity[ROE]) as the primary method tojudge business success.

The main reason profitabilitydoes not always ensure liquidity isthe system of accruals used inaccounting for profit and loss.The accrual accounting systemrecords revenues and expenses asthey are incurred, sets up accountsreceivable and inventory, estab-lishes accounts payable, capital-izes and amortizes assets, and soon to arrive at profit or loss basedon the timing of the economic

event, not on the flow of cash.Because of accounting judgmentsrequired and flexibility permitted,profit can be determined in partby the accountant’s imaginationand legitimate creativity. But cashis cash—it is real and it is precise-ly measurable. Cash managementlooks at actual cash receipts anddisbursements to arrive at theamount of cash available. Busi-ness survival is much more a mat-ter of adequate cash flow than thatintangible thing called profit.Cash, not profit, is used to pay thebills. You pay with cash, not withprofits.



Rob Reider, CPA, MBA, PhD, is the president of Reider Associates, a management and organizational con-sulting firm located in Santa Fe, New Mexico, which he founded in 1976. Dr. Reider has been a consultantto numerous large, medium, and small businesses of all types in both the private and public sectors. He isthe course author and sought-after discussion leader and presenter for more than 20 different seminarsthat are conducted nationally for various organizations and associations. He has conducted more than1,000 such seminars throughout the country and has received the American Institute of Certified PublicAccountants’ Outstanding Discussion Leader of the Year award. He is also the author of the following bookspublished by John Wiley & Sons.

• Operational Review: Maximum Results at Efficient Costs (text and workbook);• Benchmarking Strategies: A Tool for Profit Improvement; and• Improving the Economy, Efficiency, and Effectiveness of Not-for-Profits.Dr. Reider is also the co-author, with Peter B. Heyler, of the book Managing Cash Flow: An Operational

Focus (John Wiley & Sons, 2003), from which this article is adapted.Dr. Reider is also the author of the work of fiction Road to Oblivion: The Footpath Back Home, a novel of

discovery that looks at life after being downsized. For more information about Rob Reider and Reider Asso-ciates, visit his Web site at www.reiderassociates.com or e-mail him at [email protected].

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Understanding effective cash management