Introduction
Cash management is one of the essential functions of business management that affect a company’s profitability and success. For a newly-launched business like Ray’s Bonefish Paradise (RBP), choosing the right strategy is critical. Therefore, any credit policy changes should be made with consideration of the company’s specifics. This paper aims to discuss terms associated with cash management and credit policies, offering an optimal solution for the RBP company.
Cash Management
Cash management is a process of managing cash flows in a company. According to Salas-Molina et al. (2018), the ultimate goal of such an activity is to maintain adequate liquidity in the firm. Policies should ensure that current and future liabilities are covered, and surplus cash is invested for new profit generation. Firms hold cash since it provides benefits such as minimized transaction costs and the opportunity to invest with decreased cash flow.
Precautionary and Speculative Balances
Many companies wish to secure their position and protect their balance sheet. Several options can enable a safer financial state for a firm. Precautionary balance refers to a contingency fund or cash reserve held for unforeseen emergencies or unexpected funds outflow. In turn, speculative balance is cash kept by a company to take advantage in the event of an unpredictable bargain. Therefore, both practices can help a company when there is an urgent need for funds.
Specific Advantages for a Firm Holding Adequate Cash Balances
Ideally, a company’s cash is held in an adequate amount, not more or less than required. Besides, some specific advantages are associated with managing money wisely. For instance, even though most businesses operate on a credit basis, firms can get cash discounts from suppliers in case of early payment (Gamkrelidze & Japaridze, 2020). Besides, a favorable credit rating can be maintained due to adequate cash. Hence, companies can benefit from the advantages that cash management offers.
How a Firm Can Synchronize Its Cash Flows
By synchronizing cash flows, businesses can access funds when needed, thus, reducing the average cash balances and increasing profitability. A firm needs to keep digital records, practice electronic banking, and utilize agile accounting systems to synchronize its cash flows. Besides, various aspects should be considered, such as the conditions and form of payment, the growth rate of sales, cash cycle, incentive policy, and cash management. In this case, a company will benefit from synchronized cash flows and a lower cash balance.
RBP’s Disbursement Float, Collections Float, and Net Float
The calculations of a company’s disbursement float (DF), collections float (CF), and net float (NF) are based on checks issued and received. Net float means the difference between the disbursement and collection float and aims to conciliate the organization’s bank account balance and its book value. In this regard, for RBP, the calculations are as follows:
- DF = 10,000 x 5 = 50,000
- CF = -10,000 x 4 = -40,000
- NF = 10,000
Speeding Up Collections and Slowing Down Disbursements
If RBP sped up collections and slowed down disbursements, it would increase the company’s cash balance, thus, enabling it to use funds for other gainful investments. For instance, as Onyeka et al. (2018) report, firms that manage cash effectively can optimize their use of current assets and liabilities. To manage collections and disbursements, Ray’s firm can apply such techniques as float, avoidance of early payments, centralized disbursements, and accruals. This practice would be important as it allows for optimizing cash balance.
What Variables Make Up a Firm’s Credit Policy
Credit policy can be defined as guidelines determining credit and payment terms for the company’s clients. As Brenner (2017) claims, it comprises four elements: “the payment term or credit period, standards, collections and discounts” (para. 3). A relaxed credit policy would change the variables’ values, which, in turn, would increase sales, receivables, and the number of bad debt expenses. On the contrary, a credit policy’s tightening can decrease all three indicators.
The Days Sales Outstanding (DSO) and The Average Collection Period (ACP)
The days sales outstanding (DSO) measures the average number of days needed to collect payment after a sale. The average collection period (ACP) is calculated to ensure the company has enough cash available for financial obligations. DSO measures the average time required to receive payment after making a sale, similarly as ACP does. If the current policy is maintained, the DCO is about 19 days:
- DSOold= 0.625(10) + 0.32(30) + 0.055(60) = 19.15 days.
If the new policy is implemented, the DCO will be about 35 days:
- DSOnew= 0.725(20) + 0.10(45) + 0.175(90) = 34.75 days
The Dollar Amount of Discounts Granted under The Current and The Proposed Credit Policies
The current policy for RBP is 2/10 net 30, while the suggested one is 3/20 net 45. The dollar amount of discounts under the current policy is as follows:
- Discountsold = 0.02 x $3,600,000 x 0.625 = $45,000
However, if the new policy is approved, the discounts will be as follows:
- Discountsnew = 0.03 x $4,000,000 x 0.725 = $87,000
Should RBP Make the Credit Policy Change
The adoption of the proposed policy would lead to such changes in RBP’s crucial indicators:
In this regard, an increase in operating expenses and a sharp increase in DSO can lead to lower profit and cash flow issues. Hence, RBP should not adopt the suggested credit policy change.
To conclude, cash management and credit policies are crucial contributors to a company’s profitability and performance. A decision to adopt a new policy should be based on careful calculations to avoid profit loss and maintain adequate cash balance. In the given scenario, the RBP company would not benefit from the proposed changes; therefore, it is not recommended that the firm employs a new credit policy.
References
Brenner, L. (2017). What is the relationship between a firm’s credit policy & its accounts receivable? Chron. Web.
Gamkrelidze, D., & Japaridze, D. (2020). Cash management: A critical part of public finance management and its implications in light of Covid-19 pandemic. Ecoforum Journal, 9(3). Web.
Onyeka, V. N., Nnado, I. C., & Iroegbu, F. N. (2018). Effect of cash and liquid substitutes on profitability of selected quoted manufacturing firms in Nigeria. European Journal of Business, Economics and Accountancy, 6(2), 1-12. Web.
Salas-Molina, F., Pla-Santamaria, D., & Rodriguez-Aguilar, J. A. (2018). A multi-objective approach to the cash management problem. Annals of Operations Research, 267(1-2), 515-529.