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The Effective Use of Cash

Today people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value???. ~ Warren Buffett

What CASH? When Cash? WHY CASH?

Cash in its physical form is the simplest, most widely accepted and reliable form of payment. That’s the reason why many businesses prefer cash. Cheques can be bounced and credit cards can be declined but cash-in-hand requires no extra processing.

Small companies often keep a petty cash account. Cash in this account  is used for a number of processes including, but not limited to the following:

  1. It is used to purchase items outright for the business.
  2. In other cases, it may be used to reimburse an employee.
  3. Used to pay customers and suppliers when they pay the business and need change.

Some companies maintain heavy cash accounts because credit terms are not good with suppliers or suppliers don’t accept alternative form of payments in the form of bankers guarantee or other liquid money market instruments. Depending on the business, the cash requirements might widely vary.

Our goal however in this article is not to negate the importance of cash, rather to bolster it by saying that this wonderfully flexible asset can often be used for better purposes rather than as a defence against an uncertain future.


Although the above statement is true for a risk averse individual, it is quite different for a company. A company by accounting term is separate from an individual. If what comes in??? (cash inflow) is simply greater than what goes out???, it does not necessarily mean good news for the company. It is one of the reasons why understanding the cash flow statement is crucial for any company owner. A cash flow statement has essentially three parts:

  1. Operating Cash Flow
  2. Investing Cash Flow
  3. Financing Cash Flow

A company’s effective cash flow from business is measured from the operating cash flow. Investing cash outflow and inflow basically measures the company’s investment made and returns from it respectively. Financing cash flow occurs because the company cannot fund everything with its own money if it wants to grow fast, so it raises loan/debt to fund certain projects/ assets. The inflow and outflow are basically investors providing money and taking back as principal and required return respectively

So essentially if the net cash flow is judged in singularity then we might be looking at someone else’s money in our own pocket. This can be costly because if we have taken the principal, most certainly we have to pay the interest regardless of how effectively we are using the money.


Quite evidently, the most explicit cost of cash is the cost of financing because banks will explicitly state the interest rate to be paid. However, the real cost is different from the sum of all instalments of interests paid. The thing about cash is that it always depreciates. A 100 rupee will most definitely be worth less tomorrow than it is today. To calculate the real cost of cash or rather the kind of real profit your company will have after the cash comes in you need to have a few ingredients in place.

  1. You need to understand what kind of project you are taking the money for. For example, if it is to buy a machine, you need to understand what the machine will create, what the product would be sold for. What is the estimated life of the machine. Bottom line you have to estimate or rather some consultant will estimate for you the cash flow generated by the machine (not profit, cash flows i.e. profit not only written in books but is in your account). Ball park estimates can be done but it is always good to have a pessimistic estimate of cash flows. In fact, this should be done for pessimistic, normal and optimistic cash flows.
  2. The interest rate the bank is charging, if it is floating then further estimates need to be done to understand as to how this rate might change.
  3. The next step is to discount the cash flows(cash inflow due to project -cash outflow due to payment to investor in the project). This can be done using excel NPV(rate,value1,value2..). The is rate of discount and value1, value2 are series of cash flows. Here it is considered the rate is singular fixed rate. It is always good to tally your estimates of cash flows with that of your accountants.

Quite naturally no project should be undertaken in the NPV value is less than or equal to zero.

The real trouble is faced where it is no more about getting money from someone else and paying back to another. When it is not anymore a transaction. What about the cost of the cash that is already with you? It is very difficult to capture the cost of this cash because quite paradoxically this cash kept in your account is used for different business purposes as mentioned earlier and at the same time the extra cash doesn’t do any work when idle (meaning the business is not using it and since legally business is a different entity it means that it doesn’t belong to your personal account either). It is quite similar to one of your employees sitting idle. You are not paying for his salary but he is using a space in office, using the coffee machine when in an alternative situation he could have been paid a salary and made to do productive work.

The question again is that whether the work done by him is valuable enough that he deserves the salary. Coming back to cash, whether the cash can be employed somewhere and used effectively to bring more returns. What if the cash is employed somewhere else and too less cash is there for daily activities. The trade-off is real and you have to understand your business well and more importantly you have to understand the future requirements of your business to understand how much cash you need to store in your account. However, refrain from hoarding too much of cash as simply because you cannot see a cost of stored in your bookkeeping doesn’t mean it’s not there. Cash that you employ out in the world might bring you more returns but may not be liquid enough to bring back when you need it. At the same time cash in your account is not growing and if it is not growing to know this that it is depreciating.

Having said all of the above cash requirements in different businesses is vastly different and it most definitely should not be done looking at the books of some peer company. Understanding business requirements and proper consultancy is crucial before predicting cash requirements for the future.

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