Motives for holding cash
At the basic level, a firm like individuals has three motives for holding cash. These are as under:
(a) Transactional motive
(b) Speculative motive
(c) Contingency motive
(a) Transactional Motive
This is the most essential motive for holding cash because cash is the medium through which all the transactions of the firm are carried out. Some examples of transactions of a manufacturing firm are given below:
– Purchase of Capital Goods like plant and machinery
– Purchase of raw material and components
– Payment of rent and wages
– Payment for utilities like water, power, and telephone
– Payment for services like freight and courier
These transactions are paid for from the cash pool or cash reservoir which is all the time being supplemented by inflows. These inflows are of the following kinds:
– Capital inflows from promoters’ capital and borrowed funds
– Sales proceeds of finished goods
– Capital gains from investments
The size of the cash pool depends upon the overall operations of the firm. Ideally, for transaction purposes, the working capital inflows should be more than the working capital outflows at any point in time. The non-working capital inflows should be utilized for similar outflows such as the purchase of fixed assets together with the surplus of working capital inflows.
(b) Speculative Motive
Since cash is the most liquid current asset, it has the maximum potential of value addition to a firm’s business. The value addition can come in two forms. First, as the originating and terminal point of the operating cycle, cash is invaluable. But cash has an opportunity cost also and if cash is kept idle, it becomes a liability rather than an asset. Therefore, efficient firms seek to deploy surplus cash in short term investments to get better returns. It is here that the second form of value addition from cash can be had. Since this deployment of cash needs to be done skillfully, not all firms hold cash for speculative motives. Further, the amount of cash held for speculative motive should not cause any strain upon the operating cycle.
(c) Contingency Motive
This motive of holding cash takes into account the element of uncertainty associated with any form of business. The uncertainty can result in the prolongation of the working capital operating cycle or even its disruption. It is possible that the cost of raw materials or components might go up or the time taken for conversion of raw materials into finished goods might increase. For such contingencies, some amount of cash is kept by every firm.
Level of cash holding
The level of cash holding of a firm depends upon a number of factors. Prominent among these factors are the nature of the firms’ business, the extent, and the reach of the business. The level of cash is measured as a percentage of turnover of the firm.
1. Nature of the business
If the firm is engaged in cash purchase of raw material from a number of sources, its requirement of cash would be more than that of a firm that buys on credit. Also, a firm having cash purchases and cash sales would need to maintain more cash balance than a firm that buys on credit and sells on credit. A firm buying in cash and selling on credit is likely to have strained cash flows. On the other hand, a firm buying on credit and selling in cash has comfortable cash balances.
2. Extent and reach of the business
A multi-location firm having a number of large and small branches has more cash requirements than a single location firm. Also, the problems associated with moving cash between the branches and maintaining liquidity are much more in a multi-location firm.