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Reasons for Holding Cash

By:   •  December 8, 2018  •  Essay  •  1,048 Words (5 Pages)  •  330 Views

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Reasons for Holding Cash

“Cash is known as most liquid and less productive assets of a firm. If cash remains idle, earns nothing but involves cost in terms of interest payable to finance it. Although cash is least productive current assets, firm should hold certain amount of cash for marketable securities” (Account Learning, n.d.). According to John Maynard Keynes, an economist, there are three reasons or motives as to why many organizations practice holding cash or liquidity: the reasons include, transaction motive, speculative motives, and precautionary motive.


The authors of our textbook states that, a company’s speculative motive is its need to have cash on hand, in the event that an advantageous opportunity presents itself, they are ready to take advantage of it. For example, the opportunities could be cheap purchases that may arise, exchange rate fluctuations that are favorable (mainly for international companies), and interest rates that are attractive in nature (Pg. 834). Therefore, it is beneficial for firms to have cash on hand to reinvest in their business through these various opportunities; and a method companies can utilize to fulfill speculative motives is to reserve their need to borrow and have marketable securities.


Secondly, additional reason firms have for holding cash is precautionary motives. A precautionary motive is essentially a firm holding on to cash as an emergency fund or financial reserve. Hence, when expected cash inflows for a company is not received in a timely manner, the funds held back on precautionary basis will be utilized to fulfill any short-term obligations that the expected cash inflow was to be used to satisfy originally. “Since the future is uncertain, a firm may have to face contingencies such as an increase in the price of raw materials, labor strike, lockouts, change in the demand, etc. Thus, in order to meet with these uncertainties, the cash is held by the firms to have an uninterrupted business operations” (Business, Jargons, 2017). Now, even though there are very good reasons to maintain a certain level of liquidity, the liquidity of treasury bills (t-bills) and the value of money in the market place is relatively firm, making it unnecessary to hold a considerable amount of cast for any precautionary measure.


Third, transaction motive is known, as the amount of cash a business must have on hand to appropriately meet the needs of the business on a daily basis (Pg. 835). The transaction based needs are generally from the firm’s collection activities and normal distribution. The normal distribution of liquid cash for a company entails payment of salaries and wages, dividends, taxes, interests, the purchase of goods, and trade debts (Jaffe, Ross, and Westerfield, 2013). While cash collected is usually from the sale of assets, product sales, and some type of new financing. So the collections are known as the cash inflows and disbursements consist of outflows, which can be inconsistent or unsynchronized; therefore, having liquid cash on hold will serve as a cushion to a certain level.

The good news about transaction motives is as we continue to advance in technology with electronic transfers, paperless payments and other methods of rapid payment mechanisms, the transaction demand for cash will significantly decrease or disappear. In the case that it does happen, there will still a need for firms to have liquidity and the efficient management of it (Jaffe, Ross, and Westerfield, 2013).

Compensating Balance

Furthermore, compensating balances is considered an additional reason firms hold cash (Pg. 835). “A compensating balance is a minimum balance that must be maintained in a bank account, and the compensating balance is used to offset the cost incurred by a bank to set up a business loan” (Investopedia, 2010). This particular type of balance is unavailable for the firm’s usage, and when the company is preparing its financial statement, it is important to have a disclosure placed the borrower’s note. (Investopedia, 2010). The financial institution (bank) reserves the right to lend


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