Why do you need to hold cash?

Why do you need to hold cash?

By Atik Karim | Atik Karim | 12 Feb 2019


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Cash is still considered the most liquid asset. Cash is common denominator to which current assets such as- account receivables, inventories will also be converted at the end. Cash is required to purchase raw materials, equipment, other assets which are required to provide products and services for businesses. Marketable securities such as- stocks, bonds, commercial paper, T-bills and money market instruments are also can be converted into cash in a quick manner. The term cash not only limited into cryptocurrencies, coins, currency notes, cheques, bank drafts but also the marketable securities as mentioned earlier. 

In a narrow sense, cash only consider the physical money namely notes and coins. But in a broader sense, anything which is highly liquid can be considered as cash, for example- Fixed deposits in bank, short term investment, etc.

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It is pivotal to know why we need to hold cash.

There are various reasons to hold cash. Among them, there are four important motives can be taken into account when we want know the reason for holding cash.

1. Transaction Motive: In order to purchase raw materials and pay for bills and operating expenses we need to hold cash. It is crucial to meet the daily need of business operations to maintain a constant growth for the entity.

2. Precautionary Motive: We never know what is going to happen in the next moment. In order to meet the unexpected events of future it is essential to hold cash. The examples can be:

  • Natural disaster, labour strikes, opt out of bona fide customers
  • Bills which might be required to settle earlier than the scheduled period
  • Failure to collect account receivables or not able to collect the full amount
  • Customers cancellation of ordered goods due to dissatisfaction or changes of mind
  • Hike of prices in raw materials

3. Speculative Motive: This is one of my favourite reason for holding cash. It has the following merits:

  • It provides an opportunity to purchase raw materials when the prices are low
  • Purchasing securities when interest rates are low and get high return from there
  • Due to anticipating that raw materials price will be declined in near future we can hold cash and wait for the drop of the prices
  • Committing purchases at any favourable condition which will give return

4. Compensating Motive: Last but not the least, this is considered another motive of holding cash balance in order to compensate banks which provided loans and services to the business.

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Management of Cash: Many individuals earns hefty amount of cash on a regular basis, but only few of them knows how to actually manage it in a proper way which will minimize risk while providing higher yield. There are four major issues when it comes to manage the cash effectively. They are discussed as below:

1. Controlling the level of cash: The amount of cash locked should be the amount which is required, not extra or less. This can be done by preparing a good Cash Budget. Cash budget can be defined as forecasting of cash receipts and cash disbursement. It also take into account the timing and the amount of cash in and cash out. It can be estimated by studying the past transaction of business.

Cash In

a. Capital Receipts

Whatever money comes in by a way of raising funds such as- issuing shares, bonds, debentures are counted as capital receipts.

b. Revenue Receipts

When cash is received by selling products or services it can be considered as revenue.

Cash Out

a. Capital Payment

Principal payments, repayment of long-term loans included into this.

b. Revenue Payment

Payment of raw materials procurement, wages, bills, rentals, interest, coupon payments and dividends.

2. Controlling the level of inflow of cash: After preparing the cash budget accurately the finance managers need to ensure that all the cash collection are being done in a timely manner. There are multiple types of collection systems which are popular into this, such as- over the counter (OTC) collection, mailed payment collection system, pre-authorized payments, cash concentration and a lock box system.

3. Controlling the level of outflow of cash: It is also known as disbursement system. This take into account the cash payment which need to be given to the creditors. The direction of this outflow should be totally opposite inflow, which means making the payment delay as much as possible.

4. Optimum investment of surplus cash: This is responsible for investment of any surplus amount of cash, for instance, investment in markatable securities after analyzing which type of security, period of investment, liquidity, etc. Finance manager need to determine the safety level of cash first before investing. There are two popular models which can be used for determining the optimum level of cash. One is called Baumol Model and another one is Miller-Orr Model.

I will be explaining about these two models in my next post. Please stay tune. Thank you.

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Atik Karim
Atik Karim

Forever learner.


Atik Karim
Atik Karim

I am enthusiastic to learn constantly about finance mechanism and share the knowledge to others.

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