An efficient treasury and risk management calls for an in-depth understanding of concepts and treasury functions critical to ensure adequate liquidity. Discover the key treasury management concepts that every finance professional should know.
With changes in industry compliance and technology happening at a skyrocketing pace. It becomes critical for businesses to manage and optimize financial resources more efficiently than ever. This is where comprehensive knowledge of treasury management comes into play. The only way for businesses to thrive in this competitive environment is to have an in-depth understanding of treasury functions and to know when and how to optimize them for maximum yields. This blog will guide you through the key concepts of treasury management that one should have a solid understanding of.ย
Accounting Methods: Cash basis and Accrual Accounting
There are two methods of accounting: accrual basis and cash basis. While the accrual basis of accounting recognizes income and expenses. When they are incurred, regardless of cash movement, the cash basis of accounting records revenues and expenses only when cash is received or paid. It is a simpler method used in the treasury world that measures cash flow. How much cash came in vs how much cash went out over a period of time.ย
For instance, the company pays $1,200 today for a laptop. Per the US tax code, laptops last for 5 years. So rather than showing an expense of $1,200 today, the accountants can accrue $20 per month ($1,200 spread out over 5 years). But from a cash perspective, we know we spent $1,200 today and no longer have that cash for anything else.
Key Functions of a Treasury Department
The main aim of a treasury department is to manage cash fund the business and make the best use of treasury management software. Treasury departments usually run lean for both small and large businesses. Overall, the functions of a treasury Department are:
- Check how much cash they have in the morning โ make sure they have the expected cash amount and no errors or fraud has occurred.
- Predict how much cash they will need today and for the next few days โ what payments will clear for payroll, taxes, supplier checks, etc., and what cash will come in from customers, etc.
- If the company needs more cash for today or the next few days – treasurers can
(a) move cash from one location to another (e.g., from the US to the UK)
(b) borrow from lenders, or
(c) raise money through other means like selling investments.
- If the company has more cash than it needs for today and the next few days, the Treasurer can
(a) pay back lenders or
(b) invest excess cash.
Company Cash Flow Situations
Cash flows can be categorized as either positive or negative cash flows. A business being cash flow positive means it brings in more cash than it spends. A cash flow negative business means it spends more cash than it generates. However, being cash flow negative is not always a bad sign. To understand the implications of being cash flow positive or negative. A business must measure cash flows over time and recognize the natural spikes and plummets.ย
Another element of cash flow analysis involves evaluating a businessโs total debt relative to cash. A net investor would hold less debt than cash available. Whereas a net debtor will have more debt than cash, giving insights into the entityโs financial stability.ย
Based on this, there are four cash situations that a business can belong to:
- Cash flow positive | net investor โ These companies generate more cash than they spend annually, and their cash is greater than debt. Example: in 2022, Meta (Facebook) generated over $50 billion in cash from operations and had $40 billion in cash vs. $25 billion in debt.
- Cash flow negative | net investor โ These companies spend more cash than they generate annually, and their cash is greater than debt. Example: in 2020, Snowflake generated -$45 million in cash from operations and had $4.3 billion in cash vs. $200 million in debt.
- Cash flow positive | net debtor โ These companies generate more cash than they spend annually, and their cash is less than debt. Example: in 2022, Apple generated over $100 billion in cash from operations and $48 billion in cash vs. $120 billion in debt.
- Cash flow negative | net debtor โ These companies spend more cash than they generate annually, and their cash is less than debt. Example: A struggling company may have borrowed to expand, just as demand for its products declined.
Daily Cash Management
Cash management involves analyzing how much cash is available to a business that it can use to fund its operations and decide how much cash it needs to borrow or invest today and in the next few days. Typically, hereโs what a day for a cash manager looks like:
Global Cash Position: Connect with banks (e.g., Bank of America, Citibank, HSBC) to assess total cash availability.
Check Balances: Compare actual bank balances against expectations. For example, a $15M balance instead of the anticipated $10M requires investigation.
Match Outflows: Confirm outgoing transactions, identifying errors like a rejected $5M vendor wire due to an incorrect routing number.
Match Inflows: Verify expected inflows, such as customer payments, ensuring all anticipated funds are received.
Correct Errors: Resolve any discrepancies, such as fixing the uncleared wire and identifying suspicious transactions.
Confirm Cash Position: Adjust the cash position based on actual balances and pending transactions, calculating the effective cash available.
Plan for Today: Analyze expected cash activities, such as $12M in outflows versus $1M in inflows, resulting in a projected closing position of -$1M.
Make Decisions: Decide on borrowing or investing, considering costs associated with same-day borrowing versus planned loans and the returns on short-term versus long-term investments.
Execute Transactions: Draw $2M from a line of credit to cover the shortfall, send reports to the Treasurer or CFO throughout the day, and record any unexpected transactions.
For instance, if a company payroll is going out in two days. They need to fund the payroll bank account by tomorrow. Do they need to borrow to ensure the payroll account is funded, or will they have enough cash at the close of business today (after all of todayโs outgoing payments are clear) to send cash to the payroll account?
Debt and Investment Instruments
There are many ways that a business can borrow or invest cash.
- Borrowing – Most businesses have a line of credit that they can draw down and pay back as needed (like a credit card). The faster they can repay the money, the lower their borrowing costs. They can also borrow a term loan for a fixed time period.
- Investing – Businesses can also invest cash in ways that lock up cash from overnight to a few months or longer.
Additionally, businesses can also go for long-term borrowing and make long-term investments. For instance, instead of drawing down on a line of credit at a 6% annualized rate. The business can take a 3-year term loan at a 4% annual interest rate. Similarly, instead of investing in an overnight money market account at 3% annualized interest. The business can invest in a 90-day treasury bill at 5% annualized interest.
To make informed and effective decisions, a business must have a holistic view of its expected cash flow for a longer period, and not just for the mere next few days. Which makes direct cash forecasting a crucial element of effective treasury management.ย
Cash Forecasting
Most businesses use a direct cash forecast to predict daily cash in and out from the day next up to the following 12 months. Usually, they focus on the next 3-6 months. They have to predict:
- Each cash flow category, viz. accounts receivables and payables, taxes, payrolls, etc.
- Each location or subsidiary across the globe
However, a businessโs cash situation and strategy will depend on its cash situation, strategy, and how it plans to improve returns on its short term investments or if it wants to invest more money for longer periods of time. Additionally, a business may also decide to reduce borrowing costs by borrowing less money for shorter periods of time. In any of these cases, the business would still need to hold enough cash to take care of operating expenses, payroll, taxes, debt repayments, and so on.
Increase Your Treasury Productivity With The Right Treasury And Risk Management Software
Most treasurers often complain about having to spend too much time gathering data manually and then using traditional methods like spreadsheets to perform cash management and cash forecasting functions. Moreover, legacy treasury software fails to give accurate results for forecasts that are calculated for a period of more than 30 days.
The right treasury management software helps businesses streamline and automate treasury operations, including cash forecasting, cash management, and treasury payments. Additionally, it leverages advanced technologies such as artificial intelligence (AI) and machine learning (ML) and integrates with banks and ERPs to get AR/AP data. Improve ML prediction rates, and enable treasurers to achieve accurate, real-time cash forecasting. The software also automates the reconciliation process between bank statements and internal financial records. Reducing manual effort and errors and increasing cash management productivity by 70%.ย
