Page 103 - DCOM505_WORKING_CAPITAL_MANAGEMENT

Working Capital Management

Notes hold excess cash to finance such needs if and when they occur. We noted earlier that cash held for
such purposes is referred to as a precautionary balance and is usually invested in interest-
bearing assets until needed.
An alternative exists to the holding of excess cash for either of the two purposes described
above. The firm can simply borrow short-term to finance variable requirements as they arise.
Under such a policy, the firm would never hold excess cash. A firm’s choice between short-term
borrowings versus liquid assets as a means of financing variable requirements will depend on
policy decisions with respect to the firm’s long-term financial structure, particularly the mix of
short-term and long-term funds. We will discuss overall financial structure and the relationship
between maturity structure and liquidity later. Here, we take as given the long-term structure
and the amount available for investment in interest-bearing assets.

6.3.6 Investment Criteria

A firm might invest excess cash in many types of interest-bearing assets. To choose among the
alternatives, we must establish criteria based on our reasons for investing excess cash in the first
place. We are investing either temporary transaction balances or precautionary balance or both.
When we need the cash, we want to be able to obtain it – all of it – quickly. Given these
objectives, we can rule out equity shares and other investments with returns that are not
contractual and with prices that often vary widely. Debt securities, with a contractual obligation
to pay, are our best candidates. In selecting among debt securities, there are three principal
characteristics we should examine: default risk, maturity and marketability.
Default risk refers to the possibility that interest or principal might not be paid on time and in
the amount promised. If the financial markets suddenly perceive a significant risk of default on
a particular security, the price of such a security is likely to fall substantially, even though
default may not have actually occurred. Investors in general are averse to risk, and the possibility
of default is sufficient to depress the price. Given our purposes in investing excess cash, we want
to steer clear of securities that stand any significant chance of defaulting. In an uncertain world,
although there is no guarantee against the default risk, still there are securities available with
sufficiently low, almost negligible, default risk. In selecting securities, we must keep in mind
that risk and return are related, and that low-risk securities provide the lowest returns. We must
give up some return in order to purchase safety.
Maturity refers to the time period over which interest and principal payments are to be made. A
20-year bond might promise interest semiannually and principal at the end of the twentieth
year. A 6-month bank certificate of deposit would promise interest and principal at the end of
the sixth month.
The prices of fixed-income securities vary with the interest rates. A rise in market rates produces
a fall in price, and vice versa. Because of this relationship, in addition to default risk, debt
securities are subject to a second type of risk – interest rate risk. A government bond, though free
of default risk, is not immune to interest rate risk. The longer the maturity of a security, the
more sensitive its price is to interest rate changes and the greater its exposure is to interest rate
risk. For this reason, short maturities are generally best for investing excess cash.
Marketability refers to the ease with which an asset can be converted into cash. With reference
to financial assets, the terms ‘marketability’ and ‘liquidity’ are often used interchangeably.
Marketability has two principal dimensions – price and time – that are interrelated. If an asset
can be sold quickly in large amounts at a price that can be determined in advance within narrow
limits, the asset is said to be highly marketable or highly liquid. Perhaps the most liquid of all
financial assets are Treasury Bills. On the other hand, if the price that can be realised depends
significantly on the time available to sell the asset, the asset is said to have low liquidity. The
more independent the price is of time, the more liquid the asset. Besides price and time, a third
attribute of marketability is low transaction costs.

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