In an ideal world, a business would be able to pay for everything it needs from cash it has collected from customers for products delivered and services rendered. Why is this an ideal state? Our discussion of “flavours” of funds holds some clues…
It’s there!
Ready cash is available to spend immediately. That’s helpful for availing of supplier discounts. Depending on the industry and the size of the business, inputs can be 5-10% cheaper if purchased using cash.
It’s also great for moving quickly on new opportunities. If a resource or asset becomes available at short notice, it is very helpful to be able to mobilise funds quickly and be the first in line with a credible bid.
It is also verifiable - or at least it should be. Being able to point to a sack of money or provide a bank statement is more powerful than any claims a business might might make about money they are owed, or money they think they will make. Cash is comforting, tangible, real and ready.
It has already been paid for
Another great thing about cash earned from operating activities is that the cost of acquiring the funds has already been paid. (That cost was effectively the business’s COGS - cost of goods sold.) Other sources of funds have various additional costs that must be incurred, whether in the form of giving up control and claims to future profits (for equity), or a stream of future cash flows (for debt), and all the legal, administrative and transactional costs that go with acquiring those funds.
No one can tell you what to do with it
Best of all, the cash received from clients is unencumbered by restrictions. Sure, the business may have to set aside certain amounts to pay taxes, service debt, and so on, but in the main the money can be spent as management wishes. That operational freedom is quite valuable.
What are some downsides?
The attributes that makes cash so great also make it a little bit painful. Because it is accessible, tangible (sometimes) and fungible, it requires stronger monitoring and control than other funds. And there are logistical costs and risks, both when holding cash and when transacting with it. Storing cash requires vaults, accounts and security, whether physical or digital. Moving and exchanging cash requires infrastructure, co-ordination and more security.
And then there is the opportunity cost. Cash that is sitting in storage is not earning a return, and its value may be eroded by inflation. However useful it is to have cash on hand, there is an optimal point beyond which that cash should be deployed or returned to shareholders.
There a number of useful topics that branch off from here, including working capital management, corporate treasury and capital optimisation but we will leave these for another time. For now though, we can conclude by saying that cash from operations is a relatively “clean”, fungible, unencumbered source of funds, that allows a business to be nimble, decisive and self-sufficient. In subsequent posts we will look at some reasons why it’s not always feasible or desirable to rely on it, and how even though it may be a preferred source of funds, there may yet be good reasons to use others alongside it.