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As companies collect revenues and pay off their expenses, hopefully they start accumulating cash. They may reinvest that cash in operations, or as we'll learn in this lesson, they may hold cash for a number of reasons.
As companies generate revenue and pay bills, they hopefully make some profit and start accumulating cash. Depending on the economy and the financial markets, that cash might be used to pay a dividend for shareholders, repurchase stock, or invest in operations. But sometimes companies, just like individuals, will save their cash, and just like individuals, there are a number of reasons they might do so.
Speculative and Precautionary Motives
Two motives for saving cash are often referred to as speculative and precautionary motives. Speculative motives for saving cash exist when management anticipates good uses of cash in the near future. For example, perhaps the company wants to acquire a competitor or a supplier, and thinks they'll have the chance soon. Or maybe management sees the opportunity to purchase raw material or repurchase their stock at a significant discount. These possible, future opportunities are based on conjecture rather than reality; thus, they are speculative motives for management to hold cash.
Another reason, different, but similar in nature, is based on precautionary motives. Precautionary motives exist because management is worried about something unfortunate happening, and they want to have the cash to help out. For example, if the price of raw materials increase, or some large piece of equipment, central to operations needs to be replaced, it can be very disruptive if management isn't able to address the issue quickly. Holding cash as preparation for future unforeseen events is a precautionary reason to hold cash.
Running a business costs money. Bills and employees have to be paid. There are certain day-to-day costs of running a business that need to be paid in cash, which means that management needs to hold some amount of cash. This is called the transaction motive. While managers may like to anticipate income and expenses, and time the two so that they match as closely as possible, letting a transactional cost go unpaid can halt business, and that's never good.
Often, businesses take out loans and the banks that give them those loans require that the business maintain a certain amount of cash. These requirements are compensating balances. Like any other term of a loan, this is a negotiable requirement. A bank might ask for a $100,000 minimum balance of cash at all times, but the business taking the loan might negotiate and counteroffer by asking for a $100,000 average cash balance over a six-month period. This would allow the business some flexibility in managing their cash balance, but still give the bank the assurance of collateral.
Costs of Holding Cash
Generally speaking, businesses don't like to just hold cash. There is a direct opportunity cost of holding cash. An opportunity cost is the benefit you miss out on from one opportunity because you chose another course instead. In simple terms, if you have $1,000 you could either invest in stock A or use to take a trip to the beach and you choose the beach, any money you could have made by investing in stock A is an opportunity cost.
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Businesses sometimes lose opportunities when they are not able to invest their cash in new operations or expansion because of some required compensating balances. The benefit they would otherwise receive if they could invest or expand instead of sitting on the cash for the loan is the opportunity cost, and it is a cost of holding cash.
Liquidity Management vs. Cash Management
While cash is the most liquid asset, other assets are also very liquid, meaning they can be converted into cash quickly and fairly easily. Understanding how different assets, required for business, are liquid and how they can be managed is called liquidity management. For example, accounts receivables (payments owed by customers for products or services rendered) are assets that are pretty liquid. That cash will come in quickly, most within 30 days.
Another good example is finished inventory. Typically, finished inventory is liquid. It can be sold for cash fairly quickly, even if it takes a good sale to get rid of it. The same is true with liabilities, such as accounts payable. Managers can project when they'll receive cash for accounts receivable and sales, as well as when costs will hit them, and try to manage those so that there isn't a lot of idle cash. That's liquidity management.
Cash management, sometimes called treasury management, is managing the actual cash received. Businesses don't want all of it sitting in a bank account; they want to manage their cash and either use it to expand, pay down expensive debt, or do something with the cash that is more financially beneficial than just earning a little bit of interest.
As companies accumulate cash, they need to know how to manage that cash. Some of these reasons are speculative, meaning the managers think there might be some beneficial investment or use that will occur soon. There are also precautionary reasons, meaning that managers are being conservative and saving money to protect themselves against something costly happening. There are operational reasons as well, such as transactional motives, those associated with paying for the day-to-day costs that need to be paid with cash, and compensating balances, which essentially serve as collateral on loans or lines of credit. While each of these strategies has its time and place, knowing when and why to manage cash effectively is a key part of running a successful and profitable business.
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