Prentice Hall's one-day MBA in finance & accounting by Michael Muckian, Prentice-Hall, inc
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prepay some of its operating expenses. I won’t repeat that discussion here; I’ll simply piggyback on the discussion and point out that a business has an asset account called prepaid expenses, which holds the prepaid cost amounts that have not been charged off to expense by the end of the year. Usually, the amount of the prepaid expenses asset account is relatively small—although, if the ending balance were large compared with a company’s annual operating expenses, this strange 72
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state of affairs definitely should be investigated. A business manager should notice an unusually large balance in the prepaid expenses and demand an explanation.
One of the operating expenses of a business is depreciation.
This is a very unique expense, especially from the cash flow point of view (as Chapter 2 discusses at some length). I do not separate depreciation expense in Figure 5.3, although I do show a line of connection from the company’s fixed assets account (property, plant, and equipment) to operating expenses. As I explain in Chapter 2, the original cost of fixed assets is spread over the years of their use according to an allocation method.
What about Cash?
A business has one other asset not shown in Figure 5.3 or mentioned so far—cash. Every business needs a working cash balance. Recall that in the example the company’s annual sales revenue is $52 million, or $1 million per week on average. But the actual cash collections in a given week could be considerably less or much more than the $1 million average.
A business can’t live hand to mouth and wait for actual cash collections to arrive before it writes checks. Employees have to be paid on time, of course, and a business can’t ask its creditors to wait for payment until it collects enough money from its customers.
In short, a business maintains a minimum cash balance as a safety buffer. Many businesses keep rather large cash balances, part of which usually is invested in safe, short-term marketable debt securities on which the business earns interest income. The average cash balance of a business relative to its annual sales revenue may be very low or fairly high. Cash balance policies vary widely from business to business. If I had to guess the cash balance of the business in the example, I would put it at around two or three weeks of annual sales revenue, or about $2 to $3 million. But I wouldn’t be surprised if its cash balance were outside this range.
There’s no doubt that every business needs to keep enough cash in its checking account (or on hand in currency and coin for cash-based businesses such as grocery stores and gambling casinos). But precisely how much? Every business manager 73
A S S E T S A N D S O U R C E S O F C A P I T A L
would worry if cash were too low to meet the next payroll.
Some liabilities can be put off for days or even weeks, but employees have to be paid on time. Beyond a minimum, rock-
bottom cash balance amount to meet the payroll and to pro-
vide at least a bare-bones margin of safety, it is not clear how much additional cash balance a business should carry, just as some people may have only $5 or $10 in walking-around money and others could reach in their wallet and pull out $500.
Unnecessary excess cash balances should be avoided. Excess cash is an unproductive asset that doesn’t pay its way toward meeting the company’s cost of capital (i.e., the interest on debt capital and the net income that should be earned on equity capital). For another thing, excess cash balances can cause managers to become lax in controlling expenses. Money in the bank, waiting only for a check to be written, is often an incentive to make unnecessary expenditures, not scrutinizing them as closely as needed. Also, excess cash balances can lead to greater opportunities for fraud and embezzlement.
Yet having a large cash balance is a tremendous advantage in some situations. The business
B U I L D I N G A B A L A N C E S H E E T
state of affairs definitely should be investigated. A business manager should notice an unusually large balance in the prepaid expenses and demand an explanation.
One of the operating expenses of a business is depreciation.
This is a very unique expense, especially from the cash flow point of view (as Chapter 2 discusses at some length). I do not separate depreciation expense in Figure 5.3, although I do show a line of connection from the company’s fixed assets account (property, plant, and equipment) to operating expenses. As I explain in Chapter 2, the original cost of fixed assets is spread over the years of their use according to an allocation method.
What about Cash?
A business has one other asset not shown in Figure 5.3 or mentioned so far—cash. Every business needs a working cash balance. Recall that in the example the company’s annual sales revenue is $52 million, or $1 million per week on average. But the actual cash collections in a given week could be considerably less or much more than the $1 million average.
A business can’t live hand to mouth and wait for actual cash collections to arrive before it writes checks. Employees have to be paid on time, of course, and a business can’t ask its creditors to wait for payment until it collects enough money from its customers.
In short, a business maintains a minimum cash balance as a safety buffer. Many businesses keep rather large cash balances, part of which usually is invested in safe, short-term marketable debt securities on which the business earns interest income. The average cash balance of a business relative to its annual sales revenue may be very low or fairly high. Cash balance policies vary widely from business to business. If I had to guess the cash balance of the business in the example, I would put it at around two or three weeks of annual sales revenue, or about $2 to $3 million. But I wouldn’t be surprised if its cash balance were outside this range.
There’s no doubt that every business needs to keep enough cash in its checking account (or on hand in currency and coin for cash-based businesses such as grocery stores and gambling casinos). But precisely how much? Every business manager 73
A S S E T S A N D S O U R C E S O F C A P I T A L
would worry if cash were too low to meet the next payroll.
Some liabilities can be put off for days or even weeks, but employees have to be paid on time. Beyond a minimum, rock-
bottom cash balance amount to meet the payroll and to pro-
vide at least a bare-bones margin of safety, it is not clear how much additional cash balance a business should carry, just as some people may have only $5 or $10 in walking-around money and others could reach in their wallet and pull out $500.
Unnecessary excess cash balances should be avoided. Excess cash is an unproductive asset that doesn’t pay its way toward meeting the company’s cost of capital (i.e., the interest on debt capital and the net income that should be earned on equity capital). For another thing, excess cash balances can cause managers to become lax in controlling expenses. Money in the bank, waiting only for a check to be written, is often an incentive to make unnecessary expenditures, not scrutinizing them as closely as needed. Also, excess cash balances can lead to greater opportunities for fraud and embezzlement.
Yet having a large cash balance is a tremendous advantage in some situations. The business
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