Firms hold liquid asset balances for a number of reasons, including the following:
The following sections consider the importance of cash from a number of perspectives.
Cash Flows and the Cash Budget
Virtually every activity within a firm generates cash flows. As shown in, the firm’s cash balance is affected by every transaction that involves either a cash inflow or a cash outflow. Cash inflows, or receipts, occur when customers pay for their purchases, when a firm obtains bank loans, when it sells new issues of debt and equity securities, and when it sells (or collects interest on) marketable securities. Cash outflows, or disbursements, occur when a firm makes payments to suppliers, when a firm pays wages to employees, taxes to governments, interest and principal to bondholders, and cash dividends to shareholders, and when a firm repays bank loans and purchases marketable securities. Therefore, the cash balance at the end of any given period is the result of many interrelated activities.
Cash flows differ with respect to their degree of certainty. In general, future outflows are more certain than future inflows.Most expenditures (outflows) are directly controllable by a firm and, as a result, can be forecasted more easily. For example, outflows for such items as raw materials, labor, dividends, debt repayments, and capital equipment are determined primarily by management decisions and are usually known in advance of their occurrence. Inflows, in contrast, occur partly as a result of decisions made outside a firm and thus are usually more difficult to control and forecast. For example, cash inflows from sales depend primarily on the buying decisions of customers, as well as on when they make their payments.
The first step in efficient cash management is the development of a cash budget showing the forecasted cash receipts and disbursements over the planning horizon of the firm. A complete cash budget also contains a forecast of any cumulative cash shortages or surpluses expected during each of the budgeting subperiods—which is the kind of information needed in making cash management decisions.Many larger firms prepare a series of cash budgets, each covering a different time period.
For example, a firm may prepare daily cash budgets for the next 5 working days, weekly cash budgets for the next 10 weeks, and monthly cash budgets for the next 12 months. The daily and weekly forecasts are used in making short-term decisions, such as determining the amount of marketable securities the firm should purchase or sell. The monthly projections are used in longer-range planning, such as determining the amount of bank loans the firm will need. A survey of medium- and large-size companies found that over 80 percent of the respondents relied on cash budgets as a cash forecasting technique. Knowledge of a potential cash shortage ahead of time gives a financial manager ample opportunity to investigate alternative sources of financing and to choose the least costly one.
All other things being equal, lending institutions prefer to make loans to firms that have demonstrated an ability to anticipate their future cash needs. Firms that seem to be faced with frequent cash “emergencies” generally have more difficulty getting loans. Similarly, advance knowledge of a cash surplus allows the financial manager to invest in appropriate marketable securities.
A firm’s bank provides a variety of both tangible and intangible services. The most significant tangible services include the following:
The most important intangible banking service is the availability of future credit if and when the need arises. Other intangible services include the following:
Cash Flows Within a Typical Firm*
A bank is compensated for the services it provides by charging the firm explicit fees and/or requiring the maintenance of a minimum cash balance, or compensating balance, in its checking account. The bank can use this compensating balance to make other loans or investments, and the interest income realized is compensation for the various services rendered to a firm. Although some banks require firms to maintain absolute minimum compensating balances, most stipulate minimum average balances.
The monthly account fee that a bank charges a business customer is usually determined by calculating various service charges and then deducting an earnings credit on the account balance. The service charges are computed by multiplying the number of each type of transaction a firm makes per period (such as payroll checks, vendor checks, customer payments, and other deposits) by the bank’s charge per item. The earnings credit is computed by multiplying the available balance during the month (which often includes various deductions, such as the bank’s reserve requirement) by the earnings credit rate (that is, some specified interest rate).
When the total service charges exceed the earnings credit, the bank collects a fee from the customer. Due to competition among banks and differences in the methods used to compute account income and costs, service fees and compensating balance requirements for a given level of account activity vary from bank to bank. As a result, a firm should occasionally do some “comparison shopping” to determine whether its present bank is offering the best fee schedule, compensating balance requirement, and total package of services currently available.
Optimal Liquid Asset Balance
When a firm holds liquid asset balances, whether in the form of currency, bank demand deposits, or marketable securities, in effect it is investing these funds. To determine the optimal investment in liquid assets, a firm must weigh the benefits and costs of holding these various balances. The determination of an optimal liquid asset balance reflects the classic risk -versus-return trade-off facing financial managers. Because liquid assets earn relatively low rates of return, a firm can increase its profitability in relation to its asset base by minimizing liquid asset balances. However, low liquid asset balances expose a firm to the risk of not being able to meet its obligations as they come due. Effective cash management calls for a careful balancing of the risk and return aspects of cash management.
A minimum compensating balance requirement on the part of a bank essentially imposes a lower limit on a firm’s optimal level of liquid asset balances.When a firm holds liquid assets in excess of this lower limit, it incurs an opportunity cost. The opportunity cost of excess liquid assets, held in the form of bank deposits, is the return the firm could earn on these funds in their next best use, such as in the expansion of other current or fixed assets. The opportunity cost of liquid asset balances, held in the form of marketable securities, is the income that could be earned on these funds in their next best alternative use less the interest income received on the marketable securities.
Given the opportunity cost of holding liquid asset balances, why would a firm ever maintain a bank balance exceeding the compensating balance requirements? The answer is that these balances help the firm avoid the “shortage” costs associated with inadequate liquid asset balances.
Shortage costs can take many different forms, including the following:
Many suppliers offer customers a cash discount for prompt payment.Having to forgo this cash discount can be quite costly to a firm. In addition, the creditworthiness of a firm is determined at least partially by the current and quick ratios—both of which can be affected by an inadequate liquid asset balance. This, in turn, can cause a firm’s credit rating to deteriorate and make loans on favorable terms more difficult to secure in the future. The credit rating also can fall if a firm fails to pay bills on time because of inadequate cash. This can make future credit difficult to obtain from suppliers.
If a firm has inadequate liquid asset reserves, it may have to meet unforeseen needs for cash by short-term borrowing, and it may be unable to negotiate for the best terms—including the lowest possible interest rate—if its credit rating is questionable. Inadequate liquid asset balances may cause a firm to incur high transactions costs when converting illiquid assets to cash. Finally, an inadequate liquid asset balance increases a firm’s risk of insolvency, because a serious recession or natural disaster would be more likely to reduce the firm’s cash inflows to the point where it could not meet contractual financial obligations.
An inverse relationship exists between a firm’s liquid asset balance and these shortage costs: the larger a firm’s liquid asset balance, the smaller its associated shortage costs. The opportunity holding costs, in contrast, increase as a firm’s liquid asset balance is increased. As shown in, the optimal liquid asset balance occurs at the point where the sum of the opportunity holding costs and the shortage costs is minimized.Admittedly, many of these shortage costs are difficult to measure. Nevertheless, a firm should attempt to evaluate the trade-offs among these costs in order to economize on cash holdings.
Gilmer has performed empirical tests to determine if firms actually do face a U-shaped total cost function associated with the maintenance of liquid asset balances.His results were consistent with the concept of an optimal liquid asset balance as shown in
Optimal Liquid Asset Balance
The Practice of Liquidity Management
In practice, a wide variety of liquidity policies are found to exist among firms. offers a sample of the liquidity policies practiced by different firms in several industries. As the table shows, liquidity practices, as measured by the ratio of cash and marketable securities to total assets, vary significantly among industries and among firms within an industry. Utility firms, retailers, and service industry establishments, such as restaurants, tend to hold relatively lower liquid asset balances as a proportion of total assets than do firms in the automotive and computer industries.
Although this table does not provide data on small- to medium-size firms, in general it can be observed that larger firms tend to hold lower liquid asset balances (relative to total assets) than smaller firms. This is because larger firms tend to have better access to “back up” short-term financing from commercial banks or the commercial paper market. Because smaller firms have more limited credit access, they tend to hold greater liquid asset balances as a cushion against uncertain future needs for funds.
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