This section is from the book "Business Finance", by William Henry Lough. Also available from Amazon: Business Finance, A Practical Study of Financial Management in Private Business Concerns.
Closely related standards and tests apply to the proportions of cash and resources immediately convertible into cash (principally securities held for sale) to total capital, to gross volume of business, and to current liabilities.
Inasmuch as banks are devoted almost exclusively to handling cash and credit, we should naturally expect that their practice in respect to these factors would be more definitely standardized than the practice of mercantile manufacturing companies, and this is actually the case. The experience of financiers over many generations has gradually crystallized into the conclusion that in an ordinary commercial bank, which is effectively using most of its capital in its own business, that capital ought to be invested chiefly or wholly in cash or at least in cash and secondary reserves immediately convertible into cash. The proportion of cash to demand liabilities has been fixed by long experience at from 15 to 25%.
The practice of industrial concerns in handling cash is, of course, on an entirely different basis and is not so readily standardized. The proportion of cash to total capital varies from as low as 1% to as high as 16%, which has been attained by the General Electric Company. It very seldom, however, runs higher than 7 or 8%, which is considerably above the average.
The remarkable discrepancy between the practice in this respect in the United States and Canada should be noted. In the last-named country the relations between banks .and industrial enterprises are much closer than is customary in the United States. The Canadian companies depend much more largely upon bank borrowings to restore their cash balances whenever they become depleted. Nor do the banks impose the requirement, which is customary in this country, that bank balances should average at least 20 to 25% of bank loans.
The Canadian practice as outlined above is in accord with the practice in most European countries, particularly in Germany, and with the practice of European corporations operating in South America and other foreign countries. Canadian practice emphasizes the suggestion that the proportions of cash and cash resources to capital, sales, and liabilities, depend largely upon the nature of the company's banking connections. Or, to repeat the phrase used in a preceding chapter, the required amount of cash depends upon the "convertibility into cash of other working assets".
In most American industrial companies, the proportion of average cash to gross sales is about 3 to 6%. If the company is paying its bills promptly and is not overborrowing, current liabilities should not exceed 20 to 30% of annual sales. This refers, of course, to the business of manufacturing a standard article or articles which can be sold in fairly steady volume. On the basis of these figures, cash and cash resources should be about 12 to 25% of current liabilities, and this is not far from the customary showing.