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Monday, December 22, 2014

Cash May be King But Post 2

Posted by William on April 6, 2011

But if cash is king, why is availability so important?
Availability is the extent to which you can pay operating expenses, meet payroll, purchase product, etc. In other words availability is a company’s “purchasing power”, which determines whether or not a company is going to be in business tomorrow. In many ways it does not matter what your bottom line looks like, whether you are extremely profitable or are awash in red ink. Nor does it really matter whether your balance sheet shows net worth or it shows a significant deficit. The single event that puts more companies out of business is lack of purchasing power. If a company can’t meet payroll on Friday, its unlikely they’ll be around on Monday. If a company can’t purchase product, revenue will cease. This was poignantly made clear when the President of a $20,000,000 reseller was standing in the middle of his warehouse holding a purchase order from a customer for $2,400,000 while the finance company was repossessing his inventory. It didn’t matter to the finance company. The company had no availability and no “ability” to buy the product in order to fulfill the order.
Cash is Inefficient
Although cash may be king, it is an inefficient asset. For that reason, the goal is to measure and manage availability. The key to managing availability is to maximize the benefits of cash while maximizing your return. One way to do this is to use all excess cash to pay down debt. Seldom do short-term cash investments yield returns greater than the interest savings on short-term debt. Therefore, cash can “earn” more simply by paying down debt. Interest rates on short term cash investments are currently yielding anywhere from 1.8% to a whopping 4%, while most debt interest rates are from 8.5% to 21%. By paying down debt, companies can maximize their earnings, increasing bottom line return by 4.5% to 21% on cash balances whether they are invested or not. This can be accomplished through the maximization of availability. By having an adequate line of credit you can manage cash through a form of sweep account. All cash balances can be used to reduce debt daily or, weekly. Any shortages can be drawn from the line of credit.

As an example, a $40,000,000 regional reseller had $100,000 in a non-interest bearing account and $500,000 in a money market account earning about 4%, shown in Illustration B. These same balances could have been used to pay down their working capital line, which carried interest rates in excess of prime. If the reseller used the cash to reduce debt, this reseller would have given up $20,000 a year in interest income but would have saved over $40,000 in interest expense. Clearly, the reseller was better off “investing” the cash by paying down debt. Keeping in mind that the reseller’s availability would have remained the same and the reseller would have had access to the $500,000 within twenty-four hours.

Another way to maximize cash is to finance the purchase of product and take advantage of free interest periods. In the computer technology industry, most manufacturers pay fees to finance companies to subsidize interest to resellers and VAR’s. A dealer wanting to purchase product would be better to “finance” the product and take advantage of the thirty day interest subsidy, rather than paying cash.

Cash can then be used to reduce the “over thirty” day balances, working capital or A/R advances, thereby reducing interest expense. When the product purchased reaches the thirty-day mark, or the scheduled pay date, cash can then be obtained through the availability on the credit line to pay for the product.

How do you increase availability?
Producing and retaining profitability is the only real way to materially increase availability over the long term. There are however, ways to have an appreciable effect on your availability. As stated earlier, the amount of your borrowing base or, collateral value is a key component in your availability calculation. Concentrating on improving overall collateral quality will ultimately increase your availability. For example, collecting 90 day accounts and reducing old inventory will increase your borrowing base. The key is to monitor availability daily making sure total availability is in excess of one months operating expenses.

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