Analyse why it is important for businesses to effectively manage their levels of cash.

Mark scheme

Marking points from the official mark scheme (Feb/Mar 2016). The mark or mark type is shown in brackets.

1. [Level 4] Good analysis of the importance of effective management of levels of cash (7-8 marks)
2. [Level 3] Some analysis of the importance of effective management of levels of cash (5-6 marks)
3. [Level 2] Some explanation/application of the importance of effective management of levels of cash (3-4 marks)
4. [Level 1] Understanding of managing levels of cash (1-2 marks)
5. Having cash allows a business to operate.
6. Managing your cash resources and making sure you have enough to meet your needs – to pay wages, buy supplies is absolutely critical.
7. Hence importance of cash flow forecasting – cash in/cash out a key management tool – provide information about cash flow over a future period and provide the basis for action to remedy situation before it appears.
8. Cash flow management – is the control of cash – management accountants deal with a range of cash issues such as ensuring that sufficient cash is available for investment and not tied up in inventory – putting in place procedures for chasing up outstanding debts.
9. Companies looking only at earnings and not managing cash flow unlikely to survive.
10. Cash flow management is concerned with accelerating the flow of cash into the business and decelerate the flow of cash out of the business.
11. So cash flow forecasting and cash flow management are critical to the financial health and survival of a business. The simple goal of good cash flow management is to have enough cash on hand when you need it – applies to small and big businesses. There are few more critical business activities.
12. Discussion of the dangers of too much and/or too little cash.
13. [Level 4] Effective evaluation of the usefulness of liquidity ratios for external business stakeholders (9-12 marks)
14. [Level 3] Limited evaluation of the usefulness of liquidity ratios for external business stakeholders (7-8 marks)
15. [Level 2] Analysis and some application of the usefulness of liquidity ratios for external business stakeholders (3-6 marks)
16. [Level 1] Understanding of liquidity ratios (1-2 marks)
17. Liquidity ratios are used to assess the ability of a business to pay its short term liabilities – e.g. current ratio and acid test ratio.
18. They are an important measure of the short term health of a business – too little working capital and danger of illiquidity – too much working capital and ineffective use of resources.
19. Key external stakeholders include existing or potential investors – existing or potential loan providers, existing or potential suppliers.
20. These external stakeholders will use liquidity ratios to assess the extent to which the company has the necessary cash to fund its operations and plans.
21. Suppliers and other trade debtors will have a particular focus on liquidity ratios.
22. A profitable business will not survive very long if it cannot pay its daily expenses.
23. Answers may well refer to the limitations of liquidity ratios – the need to examine the particular features of a business, for example where high inventory levels are common – also need to be aware of trends – is the ratio improving or not? – and how accurate is the data? Alternatively candidates might identify that liquidity ratios are only one part of the picture.