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Motives for Holding Cash

Chapter 18 /  Lesson 1   Transcript
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  • 0:03 Accumulating Cash
  • 0:30 Speculative &…
  • 1:46 Transaction Motive
  • 2:17 Compensating Balances
  • 2:54 Costs of Holding Cash
  • 3:45 Liquidity Vs. Cash Management
  • 5:05 Lesson Summary
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Lesson Transcript
Instructor: Dr. Douglas Hawks

Douglas has two master's degrees (MPA & MBA) and is currently working on his PhD in Higher Education Administration.

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.

Accumulating Cash

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.

Transaction Motive

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.

Compensating Balances

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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You are viewing lesson Lesson 1 in chapter 18 of the course:

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Finance 101: Principles of Finance

21 chapters | 124 lessons | 11 flashcard sets

Ch 18. Cash & Liquidity Management
Ch 19. Credit & Inventory...

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