On a company's balance sheet, net cash is an indicator of financial health that should be considered carefully. Of course, a positive cash position is always desirable. But a high level of cash flow is not an objective to be pursued at all costs. What is net cash, and what implications does it have for the management of a company's financial strategy? Here are some of the answers.
What does net cash consist of?
Net cash is the difference between a company's cash holdings and its short-term debts. It therefore refers to a company's ability to meet its payment obligations to its creditors, but is also used to finance its day-to-day activities without needing to resort to external sources of finance (such as bank credit).
Net cash can be calculated using the formula:
Net cash = cash + marketable securities - short-term debt
It should be noted that :
- Cash and cash equivalents correspond to the money in the company's bank accounts.
- Marketable securities include liquid financial investments that can be released immediately (e.g. short-term bonds and other unit trusts).
- Short-term borrowings include invoices due, short-term bank borrowings and bank overdrafts.
A positive net cash position means that the company has a financial margin, while a negative net cash position indicates a dependence on external financing to cover its needs.
Treasury terminology
When it comes to cash flow, three concepts need to be distinguished:
- Active cash flow refers to the cash available to the company at a given point in time.
- Cash and cash equivalents consist of short-term payables.
- Net cash is the difference between the two. If positive, it means that the company is secure enough to pay its short-term debts
Why is it important to have a positive net cash position?
The answer may seem obvious, but let's be clear about the extent of the risk incurred if a negative cash flow situation takes hold over the long term. First of all, there is the risk of encountering payment difficulties , leading either to a deterioration in commercial relations with suppliers in the event of long delays or even non-payment, or to recourse to external financing mechanisms such as credit.
In both cases, the result is costs (procedural or interest), which further penalise the financial situation and can increase if the problem recurs.
Eventually, a company with negative net cash position that is unable to reverse the trend will find itself in a situation of insolvency. Failing this, its financial rating with investors and banking partners will deteriorate.
An essential strategic indicator in financial management
A positive net cash position is a sign of a company's good health, but it also plays a crucial role in its financial management: the constancy of an optimised positive cash position creates a virtuous circle by allowing :
- Ensure short-term solvency, to meet all its payment obligations.
- Improve investment capacity, by making it possible to finance new projects without borrowing or releasing other invested funds.
- Enhance credibility with financial partners, who will undoubtedly look at the level of net cash position index before granting financing.
- Be more resilient to unforeseen events, thanks to the security cushion that protects against economic difficulties.
A company's financial management strategy should therefore aim to maintain a certain level of net cash, without accumulating too much cash.
Cash flow and WCR, two complementary concepts
In financial management, it is essential to consider several concepts in order to have a global and strategic view. While working capital requirement (WCR) refers to the cash that needs to be available at all times to keep the business running, net cash can be seen as additional cash: that which remains available once the company has paid its debts, cash that can therefore be used in other ways - or saved. It is a residual amount whose existence proves that the company is not likely to encounter difficulties in paying its bills, at least at a given moment.
The formula for calculating net cash can then also correspond to:
Net cash = total net working capital - working capital requirement
What can you do to improve your net cash position?
In the event of negative or zero net cash position, it is essential to take action to avoid accumulating debts. There are several possible courses of action:
- Reduce the payment terms granted to customers and encourage them to pay more quickly, by discounting for example;
- Negotiate longer payment terms with suppliers;
- Limit the amount of cash tied up in inventory, by reducing it to a minimum or even by operating on a just-in-time basis;
- Avoid ongoing costs by renegotiating certain contracts and limiting recruitment and communication expenses, for example.
A company with a negative net cash position would be well advised to review its entire financial situation in order to identify the causes of the risk: overspending, poorly negotiated contracts, inadequate marketing, ineffective debt collection. The findings should enable the company to rebuild a healthier business model that is viable in the long term, with a net cash position of at least 0.
Too much net cash: a good idea?
The right level of cash flow is a totally subjective notion, which must be confronted with the context of each company. However, while a positive net cash position should reassure managers and their creditors, an accumulation of cash is not a good sign.
A company is a living organism, whose long-term survival depends on its ability to evolve: to do this, profits must be reinvested, in production capacity, commercial strength, the acquisition of another company, and so on. A company that does not invest to strengthen its capabilities when it can, is likely to generate mistrust, particularly on the part of investors.
Finally, we should point out that net cash position is an indicator to be considered over the long term, and that it is advisable to look at its real components. Certain exceptional transactions (such as the resale of equipment, for example) can give the impression of a beneficial financial situation when, without them, the net cash position would have been negative. The difficulty is then masked.
Net cash is at the bottom of the assets column on a company's balance sheet. Before entering into a business relationship, it is prudent to find out about the financial health of the partner company. If you don't have the time to examine its official documents in detail, call in a professional who can carry out a reliable and detailed investigation !
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