Searching for a Benchmark for Idle Cash Holdings

Having money sitting in bank accounts is often the expensive result of a company’s inability to forecast its cash flows. It is time for treasurers to think again about this ‘unproductive asset’ and look for ways to measure - and improve - treasury’s performance in relation to idle cash.

At the end of any commercial transaction, when the customer has paid its invoice and the cash is received in the bank account, or the customer’s cheque has cleared, a sigh of relief might go through any organisation’s finance team. The transaction that started, possibly with a customer order or a statement of work, has ended. The ordered product has been produced and delivered, or the requested services have been accepted and the risk of non-payment - because the client is unhappy with the work, or worse, the client has gone bankrupt - has been avoided.

While the finance and commercial teams will consider the transaction to have ended with the customer payment, the treasurer of the organisation might still have some work to do. The cash circle will close only when the proceeds of the transaction can be used to pay down debt, settle supplier payables or meet payroll needs.

The treasurer must move the funds from a collection account, or lockbox account, to an operating account. This might involve moving the funds across borders if the transaction involved overseas collections, or converting the funds back to the organisation’s base currency if the invoice was denominated in a foreign currency. Once the funds have arrived on an operational account, the funds can be used for the operational needs of the company, or, if the company does not have an immediate need for the funds, the cash can be moved to an investment account and invested within the guidelines of the investment policy.

An ‘unproductive’ asset

Cash that has been collected, but has not been put to use, or invested, is called idle cash. Treasurers will typically try to limit the levels of idle cash on the balance sheet. It is a largely unproductive asset for the company. In some cases, banks will remunerate their clients for keeping idle cash on non-interest-bearing bank accounts by paying ‘earnings credit’, however, that might not be a good substitute for interest income as it can only be used to offset bank charges and the company might not incur sufficient bank charges to be offset by the earnings credit potential. In an ideal world, where all flows can be perfectly predicted, idle cash will be limited to the value of uncleared receipts, and any cash held by banks while funds are in transit between bank accounts. Retail companies that have cash registers will have idle cash in the form of the notes and coins held in the registers, and businesses that still value petty cash to pay for the occasional delivery will include petty cash in the cash amounts as well.

Many companies will have idle cash because of limitations in their ability to forecast flows. On the collections side, it is hard to predict when customers will make a payment and, in some countries, inbound flows will clear close to or after the deadline imposed by the bank to transfer funds out of a collection account, making it impossible to transfer end-of-day collections into an investment account in a timely manner. Expected disbursements that were not accepted or processed in time will lead to funds remaining idle on a disbursement account. Companies that issue cheques should to maintain a buffer to ensure the bank accounts have sufficient funds for cheques to be cleared.

Cash can also be trapped overseas when it is not economically viable to repatriate the funds, either because of tax-related concerns or because inbound funds need to be used again locally in the near future, and the cost of moving funds outweighs the income generated by investing it centrally. Currency conversions take time; a spot rate is for settlement two business days later, and cash will sit on the bank account waiting to be converted. Debt instruments might have notice periods for drawing or reimbursing, creating delays between the collection of the cash and the paydown of the short-term debt. Similarly, investment instruments might also require notice periods, making very short-term investments impractical, or requiring cash buffers to be held idle to cover the time required to liquidate investments so that urgent payments are not unnecessarily delayed.

Providing a buffer

It is hard to find sufficient benchmarks for the levels of idle cash that are appropriate for a business and to measure the performance of the treasury team in managing idle cash compared with its peers. Financial reporting rules require public companies to disclose their cash holdings in a line called ‘cash and cash equivalents’. This line holds idle cash, but also items such as short-term investments. Furthermore, idle cash at quarter ends, when financials need to be reported might not be indicative of the actual balances of idle cash held on an average day. Some of the idle cash that is included in the reported cash line at a quarter end, such as received, but uncleared cheques, might not be immediately visible to the treasury team because it might not be reported on bank statements, which makes the calculation of reported idle cash difficult. What’s more, the true balance of idle cash, as treasurers perceive the number (i.e. the cash held idle on bank accounts), will only be known if bank account balances are consulted and consolidated daily.

Some corporates like to maintain large balances of short-term cash. These companies typically fund their operations using long-term debt instruments, and the cash reported on the balance sheet in the line ‘cash and cash equivalents’ is the buffer the company needs to keep to meet unforeseen liquidity needs, fund share repurchases and dividends, or even acquisitions. Other companies prefer to keep the levels of cash as low as possible, using capacity under flexible debt instruments such as revolving credit agreements to provide for the buffers they need to cover unforeseen liquidity needs.

Measuring efficiency

What is a good benchmark for the performance of a treasury or finance team for keeping idle cash low? The reported cash in the quarter end balance sheet of market leaders in three industries has been compared to find the answer to this question.

Distribution companies should be efficient in the way cash is handled. Large volumes of collections flow over the bank accounts of these companies and efficient use of inbound cash is crucial to keep the balance sheet lean. The same can be said of large retailers. Physical cash is collected via the stores and needs to move swiftly to the bank to be credited on the bank accounts, and credit card collections require some time to clear, before the funds are deposited in the retailers’ bank accounts. In order to be able to compare companies’ cash management performance we need to eliminate the impact of revenue. Cash holdings are calculated as the ratio of cash over one day of revenues, comparable to the calculation of days sales outstanding (DSO) used to calculate the speed with which companies collect their receivables. The metric could be called ‘days cash outstanding’ (DCO) and is calculated as:

Figure 1 shows the evolution of DCO over the last five reported quarters for three companies:

Fig 1: Days cash outstanding (DCO) Source: Public Reporting

The analysis shows that idle cash expressed in days at quarter end for these companies fluctuates between three and six days. Based on the reported DCO for the three companies, a benchmark of three to six for quarter end reported cash or DCO is appropriate to measure the efficiency of a company in managing its idle cash. Adjustments will need to be made for specific circumstances that require larger balances of idle cash, such as international diversification, or the need to keep large balances of petty cash. Quarter end cash is not necessarily indicative of idle cash held throughout a quarter.

With a benchmark for DCO, the treasurer or the finance team is now armed with a tool to measure how the team is doing in managing the idle cash of the company, how fast collected cash can be converted into a useful asset. They will also be able to assess the potential benefits of implementing better cash forecasting or cash management tools - such as cash pooling or in-house banking - to put unnecessary idle cash to work faster. This could be used to pay down debt, or invest, and to either reduce interest expenses or increase interest income.