Page 112 - DCOM505_WORKING_CAPITAL_MANAGEMENT

Unit 7: Cash Management

assets, they are not part of the process of selling as are inventory and accounts receivable. When Notes
firms hold cash in currency or in non-interest-bearing accounts, they obtain no direct return on
their investment. Even if the cash is temporarily invested in marketable securities, its return is
much less than the return on other assets held by the firm. So why hold cash or marketable
securities at all? Couldn’t the firm’s resources be better deployed elsewhere?
Despite the seemingly low returns, there are several good reasons why firms hold cash and
marketable securities. It is useful to think of the firm’s portfolio of cash and marketable securities
as comprised of three parts with each part addressing a particular reason for holding these
assets.

1. Cash for Transactions: One very important reason for holding cash in the form of non-
interest-bearing currency and deposits is transactions demand. Since debts are settled via
the exchange of cash, the firm must hold some cash in the bank to pay suppliers and some
currency to make change if it makes sales for cash.
2. Cash and Near-cash Assets as Hedges: Unfortunately, the firm’s future cash needs for
transactions purposes are often quite uncertain; emergencies may arise for which the firm
needs immediate cash. The firm must hedge against the possibility of these unexpected
needs. Several types of hedges are possible. For example, the firm can arrange to be able
to borrow from its bank on short notice should funds suddenly be needed. Another
approach is to hold extra cash and near-cash assets beyond what would be needed for
transactions purposes. By “near-cash assets,” we mean interest-earning marketable assets
that have very short maturities (a few days or less), and thus can be liquidated to provide
funds on short notice with very little risk of loss.

Clearly, the more of this total hedging reserve held in near-cash assets and the less held in
cash, the greater the interest earned. However, there is a trade-off between this interest
revenue and the transactions costs involved in purchasing and selling such near-cash
assets. These transactions costs have a fixed cost component; the firm bears these fixed
costs when it buys or sells these assets regardless of the size of investment. Thus, whether
it is economical to invest part or all of the hedging reserve in near-cash assets depends on
the amount of the reserve. Firms that keep smaller reserves (because their transactions
needs are either smaller or more certain) are more likely to hold these reserves in cash,
while firms with larger reserves keep them in near-cash assets.
3. Temporary Investments: Many firms experience some seasonality in sales. Often, there
will be times during the year when such firms have excess cash that will be needed later in
the year. Firms in this situation have several choices. One alternative is to pay out the
excess cash to its security holders when this cash is available, and then issue new securities,
later in the year when funding is needed.

!

Caution However, the costs of issuing new securities usually make this a disadvantageous
strategy. More commonly, firms will temporarily invest the cash in interest-earning
marketable securities from the time the cash is available until the time it is needed. Proper
planning and investment selection for this strategy can yield a reasonable return on such
temporary investment.
All of these are valid reasons for holding cash and marketable securities in response to the needs
and uncertainties faced by the firm. In fact, firms generally hold a surprisingly large portion of
their assets in these forms, despite the disadvantage of low returns.

LOVELY PROFESSIONAL UNIVERSITY 107