Cash is King is an expression that is especially pertinent in times of economic confusion, doubt and uncertainty times like we live in now. From the possible collapse of the Eurozone to questions about tax rates, debt ceilings and the constitutionality of large new entitlements, there is a lot of uncertainty out there. That is why it is as important as ever for both individuals and companies to have flexibility built into their financial plans.
Financial flexibility shows itself in several different forms. For individuals, having an emergency fund with several months of living expenses is one favorite tool of the financially flexible. Having what one financial writer calls overhang the positive difference between income and expenses is another key characteristic of the flexible. With a large overhang and an adequate emergency fund, there is plenty of cushion that will help absorb the blows from lifes disruptions. And that is what financial flexibility is all about.
Both of these ideas are staples of financial advice given to individuals. However, there are other suggestions given to individuals that tend to reduce flexibility and can cause serious problems if disruptions come. One favorite is to encourage shorter mortgages (15 years instead of 30) with the idea that people will own their homes sooner, save tens of thousands of dollars in interest, and be able to retire in peace without the large monthly payment for their housing. The problem is that signing up for a 15-year mortgage immediately reduces flexibility because one is now locked into a series of monthly payments that could be $500-$1,000 higher than they would otherwise be. If you know youll be gainfully employed for the foreseeable future, this isnt necessarily a problem. But, as many people in the Treasure Valley can tell you, it is hard to get at all that equity youve built up if you lose your job and the housing market stinks. You may be far better off by using that $500 to $1,000 each month to make sure you have plenty of flexibility.
In academic circles, this idea of flexibility is captured by the phrase financial slack. Defined as financial resources in excess of what is required to run the day-to-day operations, financial slack provides a buffer for a business when things dont go according to plan. A number of studies in the fields of both finance and strategy show firms with more financial slack are better able to exploit opportunities and have superior performance compared to firms with less slack. Having financial slack gives managers greater discretion and allows a company to better use managerial talent. If managers arent constantly worried about where the cash will come from to pay this months bills, they can better serve current customers and look for ways to serve new ones.
Can too much flexibility or slack be a negative? Certainly and there is a whole body of research examining agency problems when managers have too much cash at their disposal and waste it. While financial flexibility is not the only thing a business (or household) should think about, it certainly needs to be considered. Making decisions with an eye to how it affects your flexibility may be the thing that allows you to keep going when things hit the fan.
SCOTT ROARK Assistant professor of marketing and finance at Boise State University