Chapter 1

Cash Flow
Disruptions

Failure to keep track of money may cause a business to fail. By

not monitoring its cash—measuring it, investing it, borrowing it, and
collecting it—an otherwise profitable operation can erode into insol-
vency. Without proper cash flow, a company cannot pay its bills on
time, which may injure its credit rating. Bankruptcies are caused by lack
of cash as well as by inability to earn a profit.
Having “enough” cash means having what’s needed ready at the
right time. Poor cash flow can cause loss of attractive opportunities,
such as the ability to buy inventory at bargain prices or to pay vendors
early to earn a discount. Businesses need adequate cash flow to pur-
chase merchandise for resale, meet operating expenses, and pay debt. A
situation in which a company must advise a lender, a creditor, or the
Internal Revenue Service that it cannot pay indicates a lack of manage-
rial competence. It is important to find ways to accelerate cash inflows
and delay cash outflows.
The problems discussed in this chapter are:
• Inadequate cash position.
• Surplus funds.
• Delayed customer payments.
• Paying cash too soon.
• Cash outflows exceeding cash inflows.

1
2 Chapter 1

• Going broke while maintaining profits.

• Inefficient use of cash.

PROBLEM
INADEQUATE CASH POSITION
SYMPTOM
Cash is unavailable to pay operating expenses as they arise—to buy
inventory, to pay debt, to meet dividends, or to support expansion poli-
cies. A portion of the cash may be restricted (for example, a compen-
sating balance does not represent “free” cash).
CAUSES
The firm’s day-to-day operations are imperfectly synchronized.
• Contractual obligations require that the firm retain a minimal bal-
ance at all times.
• The company is required to hold cash balances to compensate
banks for services provided.
• Weak collection policies leave the firm showing a net income but
lacking liquid funds. (You can go broke while making a profit.)
• Cash is unavailable because it is held in a politically unstable for-
eign country, in a time deposit, or in a temporary escrow account.
ANALYSIS
Managers must determine what percentage of the cash balance is
unavailable for use. Liquidity is improved when earnings are backed up
by cash. A declining flow of cash from operations into net income indi-
cates a cash flow problem. Look at:
• Cash flow generated from operations before interest expense.
• Cash flow generated from operations less cash payments required
to pay debt principal, dividends, and capital expenditures.
• Cash reinvestment ratio (cash employed/cash obtained). Cash
employed equals increase in gross plant and equipment plus
increase in net working capital. Cash obtained equals income after
tax plus depreciation. A high cash reinvestment ratio indicates that
more cash is being used in the business.
Cash Flow Disruptions 3

Examine the trend in the ratio of sales to cash. A high turnover rate
points to cash inadequacy. Financial problems may arise if further
financing is not available at reasonable rates.
The manager must compute the following ratios:
• Cash from sales to total sales. A high ratio means that sales are
generating cash flow. It also indicates quality sales dollars.
• Cash debt coverage—cash flow from operations less dividends
divided by total debt. Cash flow from operations less dividends is
referred to as retained operating cash flow. This calculation indi-
cates the number of years current cash flows will be needed to pay
debt. A high ratio shows that the company can repay its debt.
• Cash flow from operations less dividends divided by the current
maturities of long-term debt. This ratio can be adjusted further by
adding to the denominator current liabilities or other fixed com-
mitments, such as lease obligations.
• Cash dividend coverage—cash flow from operations divided by
total dividends. This ratio reflects the company’s ability to meet
current dividend obligations from operating cash flow.
• Capital acquisitions ratio—cash flow from operations less divi-
dends divided by cash paid for acquisitions. This ratio reveals the
company’s ability to finance capital expenditures from internal
sources.
• Net cash flows for investing activities divided by net cash flows
from financing activities compares the total funds needed for
investment (purchase of fixed assets and investments in securities)
to funds generated from financing (debt and equity).
• Net cash flows for investing divided by net cash flows from oper-
ating and financing activities. This compares the funds needed for
investment to the funds obtained from financing and operations.
• Cash return on assets—cash flow from operations before interest
and taxes divided by total assets. A higher ratio indicates a greater
cash return on assets employed. However, this ratio contains no
provision for replacing assets or for future commitments.
• Cash flow from operations divided by total debt plus stockholders’
equity. This indicates the internal generation of cash available to
creditors and investors.
4 Chapter 1

• Return earned by stockholders—cash flow from operations divid-

ed by stockholders’equity.
REPAIR
• Shore up finances immediately either by incurring debt or by issu-
ing preferred or common shares to bring in the cash needed to
operate effectively.
• Establish open lines of credit (or try to refinance if rates have fall-
en).
• Sell assets to generate cash.
• Enter into sale-leaseback arrangements.
• Postpone cash payments where possible.
• Rent rather than buy.
• Make only those cash payments necessary to maintain current
operations.
• Reduce selling prices on products to generate cash flow.
PREVENTION TECHNIQUES
• Check the credit standings of new customers with TRW and Dun
& Bradstreet.
• Analyze cash collection and disbursement processes, since these
areas can be exploited to manage cash holdings more effectively.
• Analyze customer payment history, such as average number of
days beyond term. Send past due notices and make phone calls
promptly.
Policies should be designed to take advantage of float in the
payment and disbursement system. To speed cash collections, cus-
tomers should be instructed to send their payments to the compa-
ny’s headquarters or a nearby collection center to minimize mail
delay. Customers can also be instructed to mail payments to a post
office box only a few hundred miles away. The box should be
emptied several times a day. Large checks, for example, those over
$1 million should be picked up by courier rather than having cus-
tomers mail them. Customers who make the same purchases every
month can give the seller a preauthorized check (PAC) that allows
the seller to write a check on the payor’s account and deposit it at
an agreed time. This procedure will eliminate the mail float.
Companies should pay bills on time, not after but also not before
Cash Flow Disruptions 5

they are due. Set up checking accounts in areas located a long dis-
tance from suppliers. This will increase the time it takes for a
check to clear the banking system for eventual payment. For a sell-
er large incoming cash payments can be made by wire transfer or
through an automated clearinghouse to give faster access to the
cash proceeds.
• Improve credit and collection policies. Encourage cash sales. For
credit sales insist on a significant down payment and short pay-
ment terms. Charge interest on delinquent balances.
• Extend the maturity dates on debt to retain cash longer.
• Prepare cash forecasts to improve financial planning. The fore-
casts will help you be prepared for problem times when the cash
position will be weak.
• Engage in joint ventures where the other company provides the
cash funding.
SPILLOVER EFFECTS
If financing is available, a deficient cash position will mean you pay
higher interest on loans and creditors will place restrictions on the busi-
ness. A company that is out of cash cannot operate effectively. The
result is declines in liquidity, profitability, and growth, and possible
insolvency and bankruptcy.

See also in this chapter: CASH OUTFLOWS EXCEEDING CASH

INFLOWS, DELAYED CUSTOMER PAYMENTS, GOING BROKE
WHILE-MAINTAINING PROFITS, INEFFICIENT USE OF CASH,
and PAYING CASH TOO SOON.

PROBLEM
SURPLUS FUNDS
SYMPTOM
Funds in the cash account are increasing while current liabilities remain
relatively unchanged.
6 Chapter 1

CAUSE
Cash generated from operations, investments, and financing is not being
reinvested.
ANALYSIS
Short-term liquidity ratios can be used to determine whether surplus
funds are excessive and nonproductive. Cash flow from operations to
current liabilities is an effective ratio for measuring surplus funds. A
ratio that keeps increasing can indicate that cash inflows need to be
invested. However, cash from investments and financing should also be
taken into account.
REPAIR
Companies often accumulate cash they do not need for current needs or
operations. This surplus cash can be invested in marketplace securities
or used to reduce outstanding debt or increase compensating balances at
banks. When investing excess funds, firms must weigh the safety of the
security against its liquidity, maturity, and yield. A survey of cash man-
agers from the Fortune 1000 list of large industrial firms found that
Eurodollar CDs, commercial paper, domestic CDs, and repurchase
agreements were the most popular vehicles for their short-term invest-
ing. Aggressive cash managers ranked yield first, security second, and
maturity third. More conservative (moderate) managers ranked security
above yield, with maturity still third.
PREVENTION TECHNIQUES
• Use surplus funds to enhance earnings.
• Formulate a formal investment policy detailing sources of surplus
funds, types of eligible investments, parameters of investment
size and duration, executives authorized to make investment deci-
sions, transaction reporting requirements, and parties with whom
transactions can be made.
• Pay down debt regularly from operating profits.
Cash Flow Disruptions 7

SPILLOVER EFFECTS
Having too much cash on hand can mean lost opportunities to earn a
financial return. Acompany that does not use its cash efficiently can even-
tually expect problems with financing, reduced growth, and lower profits.

See also in this chapter: INEFFICIENT USE OF CASH.

PROBLEM
DELAYED CUSTOMER PAYMENTS
SYMPTOMS
• Inability to collect an unusually large number of accounts receiv-
able.
• Customers paying later than usual and not in full.
CAUSES
• Clients are experiencing declining profitability and depressed eco-
nomic conditions.
• The company’s credit department is inexperienced and ineffective.
ANALYSIS
The longer the collection period on an account receivable, the higher the
company’s receivables investment and the higher its cost of extending
credit to customers. The bad-debt ratio, which is the portion of accounts
receivables that is never collected, is one general measure of the poten-
tial for debts to go bad. The higher the ratio, the greater the cost of
extending credit.
REPAIR
• Offer cash discounts to customers for early payment. This will
speed up the collection of accounts receivable and thus reduce the
company’s receivables investment and associated costs. Offsetting
these savings is the cost of the discounts that are taken, so imple-
ment a discount policy only if the return on funds obtained from
early collection is greater than the cost of the discount.
• Reduce the delay in receiving customer payments by:
8 Chapter 1

— Sending notices or letters requesting payment of the past-due

amount.
— Telephoning or visiting the customer.
— Employing a collection agency.
— Taking legal action.
• Refuse to make new shipments until all past-due receivables are
paid.
• Send coded return envelopes or custom preaddressed stamped
envelopes with invoices.
• Send bills to customers when the order is shipped. The sooner a
bill is received, the faster it will be paid.
• Correct invoice errors immediately. A customer will not pay a bill
until it is correct.
• Require deposits on large or custom orders, or require and bill for
progress payments as the work progresses.
• Set up a system to handle seasonal peak loads to avoid invoicing
delays.
• Use COD terms for marginal customers.
• Charge interest on accounts receivable that are past due. If the cus-
tomer has a financial problem, ask for a postdated check.
• Have customers use electronic funds transfer (EFT). With EFT, a
fund transfer is credited to your bank account the same day it is
charged to the customer’s account. As a result, the payment float
disappears, because funds are instantly available. Because it is a
paperless transaction, fewer receipts are lost or stolen.
• Use customer credit cards, which are automatically validated at
the retail store.
PREVENTION TECHNIQUES
To enjoy the benefits of expeditious check clearance at low cost, insti-
tute a lockbox system. Under this system, regional collection offices
(such as a post of flee box or private mail box) are set up. Customers are
asked to send their checks to the box in their geographic region, where
a local bank picks up the checks for immediate deposit. The receiving
bank remits to the company a list of checks received by account, a daily
total, and any remittance documents. A returned-check document in the
form of a paper or card readable by an optical character recognition
device gives the business earlier notification of bad checks.
Cash Flow Disruptions 9

Before choosing this option, the corporation should determine the

average dollar amount of checks received, the cost of clerical operations
eliminated, and the interest earned because of the reduction in mail float
days. Because per-item processing cost is usually significant, a lockbox
is most advantageous for low-volume, high-dollar collections, but as
technological advances lower the cost, the system is becoming increas-
ingly available to small businesses with high-volume low-dollar
receipts.
Cash may also come in faster if customers have given the company
permission to automatically charge their accounts. This is referred to as
a preauthorized debit (PAD). PADs save a company the costs of pro-
cessing invoices and payments. They work well for repeated consistent
charges at regular time intervals.
Lastly, through the use of debit cards at an automatic teller machine
(ATM), funds may be transferred electronically from the customer’s
account to the account of the small business.
SPILLOVER EFFECTS
A delay in receiving customer payments may create a cash flow prob-
lem because the company is not receiving the funds it needs to go on
operating. Because the firm also loses a return on the delayed cash since
it cannot invest the money, profitability will be adversely affected. In
the extreme case, if the company does not receive needed cash, it may
risk insolvency and failure.

See also in this chapter: CASH OUTFLOWS EXCEEDING CASH

INFLOWS, INEFFICIENT USE OF CASH, and INADEQUATE
CASH POSITION.

PROBLEM
PAYING OUT CASH TOO SOON
SYMPTOMS
• Poor cash position.
• Impaired credit rating.
• Making full payments on accounts.
10 Chapter 1

CAUSES
• Poor cash management.
• Improper cash analysis and poor decision-making.
• Lack of standardized payment procedures.
• Failure to use the most up-to-date cash planning, and computer
software and cash models.

ANALYSIS
The savings in delaying cash payment should be computed. The busi-
ness may earn a useful return on the cash by holding it longer.
Example: Every two weeks the company issues checks to cover
payroll that average $500,000 and take three days to clear. The CFO
wants to find out how much money can be saved annually if the trans-
fer of funds from an account that pays 0.0384 percent per day (an annu-
al rate of 14 percent) is delayed for three days.
$500,000 x (0.000384 x 3) = $576.
Savings per year = $576 x 26 payrolls per year = $14,976.

Cash models should be used in cash management to minimize the

sum of the fixed costs of transactions and the opportunity cost of hold-
ing cash balances.
REPAIR
• Never pay vendors early.
• Take longer to pay tolerant creditors as long as there is no finance
charge and no impairment of credit.
• Decide who should be paid first and who last.
• Deposit funds into checking and payroll accounts only when
checks are expected to clear. Many full-service banks that offer
customers consulting services point out structural defects in the
Federal Reserve and other collection systems that allow a business
to extend the payment period.
• Make partial payments or postdate checks, or both.
• Ask for more information about an invoice before paying it.
• Mail payments late in the day or on Fridays.
• Use cash models for cash management.
Cash Flow Disruptions 11

PREVENTION TECHNIQUES
• Centralize the payables operation so that debt may be paid at the
time most beneficial to the company.
• Use payment drafts, in which payment is not made on demand.
Instead, the draft is presented for collection to the bank, which in turn
goes to the issuer to accept it. Adraft may be used to allow for inspec-
tion before payment. When approved, the business deposits the
funds. As a result, a smaller checking balance is required.
• Draw checks on remote banks.
• Mail from post offices with limited service or where mail has to go
through numerous handling points. Checks can also be mailed from
a location far removed from both the payee and payer banks.
• Use probability analysis to determine the expected date for checks
to clear.
• Use a charge account to lengthen the time between buying goods
and paying for them.
• Avoid prepaid expenses.
• Use noncash consideration, such as stock or notes, for compensa-
tion.
• Delay the frequency of payments to employees. Avoid giving cash
advances for travel and entertainment or loans. Have a monthly
rather than a weekly payroll. When finances are really tight, ask
employees to take furloughs (e.g., two weeks off without pay) or
give up a current paycheck to be paid at a later date.
• Pay commissions on sales when receivables are collected rather
than when the sales are made.
• Use barter arrangements to avoid cash payments.
• Use cash flow software for day-to-day cash management, planning
and analyzing cash flows, and determining payment dates.
SPILLOVER EFFECTS
The result of paying early is less cash on hand, less liquidity, a lower
rate of return earned, and possibly higher financing costs. This may
result in cash problems and a decline in profits.

See also in this chapter: CASH OUTFLOWS EXCEEDING CASH

INFLOWS, DELAYED CUSTOMER PAYMENTS, INEFFICIENT
USE OF CASH, and INADEQUATE CASH POSITION.
12 Chapter 1

PROBLEM
CASH OUTFLOWS EXCEEDING CASH
INFLOWS
SYMPTOMS
• Declining profits.
• Cash flow problems.
• Increased use of credit lines.
• Failure to pay bills or debt on time.
CAUSES
• Slow collections from customers.
• Low profit margin.
• Paying bills before their due date.
• Failure to expedite the collection of accounts receivable.
• Failure to reduce the lag between when customers pay their bills
and when the checks are converted into cash.
• Overspending.
• Excessive debt.
• Failure to fully assess a customer’s credit risk.
ANALYSIS
To effectively control cash flows, management must understand the
basic difference between accounting profits shown on the bottom line of
the income statement and economic profits (cash flows).
REPAIR
• Speed up collections by offering discounts and relaxing credit
standards—but beware of creating more bad debts.
• Stretch payables as long as possible.
• Sell off assets to reduce debt.
• Pay expenses and other obligations only at their due date.
• Buy used assets rather than new ones.
PREVENTION TECHNIQUES
• Establish a line of credit with a bank.
• Actively manage receivables.
Cash Flow Disruptions 13

• Spend more time on efficient management of accounts payable.

• Use cash management models that can help determine the optimal
cash that a company should have available for operations. (See
above, PAYING CASH TOO SOON, for a full discussion of cash
models.)
SPILLOVER EFFECTS
When its cash outflows exceed inflows, a company may have to finance
expansion at premium borrowing rates, thereby reducing profit margins.
This often leads to a sacrifice of quality because the business can no
longer afford extra staff, or necessary expenditures. Inadequate cash flow
will also result in lower credit ratings, decline in the market price of the
company’s stocks and bonds, inability to make profitable investments at
the right time, and, in severe cases, insolvency and bankruptcy.

See also in this chapter: DELAYED CUSTOMER PAYMENTS,

GOING BROKE WHILE MAINTAINING PROFITS, INADEQUATE
CASH POSITION, and INEFFICIENT USE OF CASH.

PROBLEM
GOING BROKE WHILE MAINTAINING
PROFITS
SYMPTOMS
• The company shows a profit but has no cash.
• Management mistakes accounts receivable for cash and makes
daily payments for inventory, payroll, and taxes.
• The company fails to budget properly for capital expenditures and
emergencies.
CAUSES
• Failure to institute an effective cash management system.
• Failure to write a realistic business plan that estimates financial
needs, identifies corporate strengths and weaknesses, and sets
profit goals and policies.
• Overspending and excessive debt.
14 Chapter 1

ANALYSIS
The company must have a plan for cash inflows and outflows. It must
also institute an effective cash collection policy.
REPAIR
• Study the cash flow cycle of the business.
• Prepare a monthly or quarterly cash budget forecast.
• Calculate current ratios to determine whether they are within the
normal industry range.
• Bill credit sales promptly and maintain realistic credit policies.
• Use COD terms for chronic slow payers.
PREVENTION TECHNIQUES
• Establish both a lockbox system and regional offices for rapid pro-
cessing of checks that originate at distant points.
• Obtain working capital from suppliers of merchandise, materials,
and equipment by buying from suppliers who do not demand
immediate payment.
• Use domestic letters of credit, whereby a bank makes a written
commitment on behalf of a buyer to pay the seller for goods
shipped.
• Lease an asset instead of purchasing it.
• Pay overtime to reduce the need to hire additional workers.
• Hire temporary help for peak periods to reduce compensation
costs in a labor-intensive business.
SPILLOVER EFFECTS
If financing is available at all, a company with a deficient cash position
will have to pay higher interest rates on loans and accept restrictions on
the business. Because a company that is out of cash cannot operate
effectively, its profitability will decline. Management may face a net
operating loss for a given period even if cash flow has increased.

See also in this chapter: CASH OUTFLOWS EXCEEDING CASH

INFLOWS, DELAYED CUSTOMER PAYMENTS, and
INADEQUATE CASH POSITION.
Cash Flow Disruptions 15

PROBLEM
INEFFICIENT USE OF CASH
SYMPTOMS
• The company does not have enough cash to meet current debt obli-
gations.
• There is more cash on hand than is necessary to cover operations,
but it is not generating investment income.
• The profit margin is falling.
CAUSES
• Inefficient collection procedures.
• Poor disbursement policies.
• Buying too much inventory or too many capital assets.
• Inefficient use of tax deferral techniques.
• Overinvesting in short- or long-term assets.
ANALYSIS
A company’s ability to sell what it produces and collect receivables is
fundamental to its success. A cash flow statement is the best tool for
measuring cash inflows and outflows. It outlines cash flows from oper-
ating, investing, and financing activities and shows the net change in
cash and cash equivalents for each period.
Use comparative analysis to identify important ratios that reveal the
correct collection time and the correct average inventory holding peri-
od for the business. (See Chapter 5: INADEQUATE LIQUIDITY and
INADEQUATE WORKING CAPITAL.) As you study these ratios, it is
important to compare them to industry norms.
Example: A company has collected the following data on average
collection periods and average accounts receivable investments for two
periods.

Current Prior
Average collection time (in days) 55 44
Average accounts receivable investment
(per $1,000 in daily sales) $55,000 $44,000
16 Chapter 1

Measured against the previous collection period, in the current peri-

od there is an 11-day increase in the average collection period. This pro-
duces an $11,000 decrease in the company’s cash capability for each
$1,000 in daily sales. Management must also compare the company’s
collection time with that of competitors.
REPAIR
• Avoid expensive overinvestment in fixed assets.
• Make a reliable forecast of projected cash inflows and outflows
and of their timing.
• Use a zero balance account (ZBA) to speed up cash inflows and
slow down cash outflows. In a ZBA, a master account is set up to
receive all checks coming into the system. As checks clear through
the ZBA, funds are transferred to other accounts from the master
account. Thus funds are transferred on a daily basis to cover
checks that have cleared, leaving a zero balance at the end of the
day.
• Have customers mail their payments to nearby collection centers
to minimize mail delay.
PREVENTION TECHNIQUES
• Use billing and collection procedures that reduce the time between
shipping, invoicing, and second notices.
• Take advantage of vendor discount policies for early payment.
• Use cash flow software to help prepare budgets and cash flow
forecasts and to time payables.
• Anticipate the total cash capability necessary for an investment in
fixed assets.
SPILLOVER EFFECTS
When cash outflows exceed cash inflows, a company may be unable to
pay debts as they become due. It will then face strict loan terms from
banks and stringent credit terms from vendors. Inability to pay cash div-
idends might affect the price of the company’s stock and its ability to
raise additional capital. Because a company with minimal cash avail-
ability cannot operate effectively, its profitability will decline, perhaps
leading to insolvency and then bankruptcy.
Cash Flow Disruptions 17

See also in this chapter: CASH OUTFLOWS EXCEEDING CASH

INFLOWS, DELAYED CUSTOMER PAYMENTS, INADEQUATE
CASH POSITION, INADEQUATE LIQUIDITY, PAYING CASH
TOO SOON, and SURPLUS FUNDS.