Use it or lose it: optimizing "cash on hand" in a Defense Working Capital Fund Organization - Financial Trends in Program Management

Program Manager, July-August, 2002 by Mark Lewis

As clearly illustrated in David Breslin's "Opportunities for Working Capital Fund Organizations and Their Customers," published in the May-June 2002 issue of Program Manager organizations financed by the Working Capital Fund (WCF) often have trouble deciding when to spend their discretionary money Their typical dilemma: should we invest in that equipment, that facility, or those computers now--or should we wait six months?

Everybody's Right

Conservatives will want to wait until the end of the fiscal year to make sure the expected revenues arrive. Contracting officers may feel more comfortable awarding contracts in the first or second quarters of each fiscal year. Aggressive money managers will want to spend it all ort Oct. 1. Each opinion has merit, but the management style of the organizations leaders will determine the timing. Because conservatives abound throughout DoD, this article explores the poorly understood aggressive approach. Hopefully some of you will convert.

Show Me the Money

Cash is the most liquid form of assets. In most settings, people understand "Cash on Hand" to be the balance of the organizations cash account--highly liquid assets directly controlled by the organization to Facilitate day-to-day operations. Working Capital Fund organizations don't have stacks of $100 bills stashed in wall safes, but on the books they still have cash accounts, with cash being generated each day from overhead. While cash is necessary in almost all business environments, the cash balance (or stated differently "the cash on hand") is to be minimized since cash is a "non-earning" asset. Its rate of return to the organization is zero at best, while high rates of inflation can significantly reduce its value. To best use your cash, convert it as quickly as possible into revenue-generating facilities, equipment, or other forms of less liquid assets.

More Aggressive Cash Management = More Efficient Cash Management

Optimizing the amount of cash on hand is simply a cash flow exercise: forecast expected monthly cash receipts and then subtract expected monthly cash pay-outs. If this value (i.e., the balance of the cash account) is expected to remain positive throughout the year, convert the excess cash into working assets. In the private sector the theoretical goal is to keep the cash balance as close to zero as possible, while staying positive to avoid expensive short-term external financing. Most organizations should hold only the minimum amount of cash needed in the short term.

In practice, management sets the minimum cash balance at a level below which they do not wish to fall. This "safety stock" reduces the organization's risk should unexpected opportunities or problems arise. Under conditions of relative certainty (like in the DoD), managers reduce the level of "safety stock" to make more cash available for operations or investments. During periods of increased uncertainty we increase "safety stocks" to deal with contingencies.

More aggressive cash management (i.e., dramatically more spending early in the fiscal year) equates to more efficient cash management.

Crunch, Crunch, Crunch..

Figure 1 might represent the cumulative monthly revenue (inflation adjusted) for a typical WCF organization over six years. These data show a predictable revenue pattern, especially considering the uncertainty associated with Continuing Resolution Authority.

Let's say the Command policy is to generate cash at 3.5 percent the rate of revenue. Therefore, monthly cash generation (i.e., "cash receipts") can be determined. Figure 2 on the next page, again, shows a predictable trend where statistical regression provides the best-fit curve:

Y = 5383.4X 230.3X2; where y is thousands of dollars, and x is month (i.e., 1 to 12); the coefficient of determination is 0.996.

The 90 percent Upper and Lower Confidence Intervals (UCI and LCI) are shown in Figure 2. Predicting future "cash receipts" solely from historical data is statistically improper, but you can gain valuable insight about your organization's financial trends through this approach. For example, we are 90 percent sure that at least $86 million in cash will be generated each fiscal year, all other factors being equal. Figure 3 shows the same data, but with 95 percent confidence intervals. We are 95 percent sure at least $84 million in cash will be generated.

Free Money

Private firms hold cash for four reasons: 1) to take advantage of discounts when purchases are made with cash; 2) to maintain a credit rating (lenders prefer to see high liquidity); 3) to take advantage of unexpected business opportunities; and 4) to address emergencies.

Only the last two points are relevant for use throughout DoD, and it can be argued that government bureaucracy delays action on most opportunities into future fiscal years (precluding the need to stockpile cash to address the opportunities). Obviously your WCF organization can hold relatively less cash than private firms can.

Let's say that the analysis of your past "cash receipts" and "cash expenditures" shows that your Command's cash balance (i.e., receipts less expenditures) has historically stayed in the black throughout the fiscal year (Figure 4, p. 75). If your Comptroller was aware of the situation, you might have even been criticized for your inefficient use of funds.