Cash is the medium of exchange on the common purchasing power and which is the most important component of working capital. It includes coins, currency, cheques held by the firm and the balances in its bank accounts. Sometimes near-cash items also are included.’ Cash is the basic input required to keep the firm running on a continuous basis. At the same time it is the ultimate output expected to be realized by selling goods and services. A firm should hold sufficient cash, neither more, not less. An excessive cash remains idle which simply increases the cost without contributing anything towards the profitability of the firm and in the opposite case, trading and/ or manufacturing operation will be disrupted. Not only that, it largely upholds, under given condition, the quantum of other ingredients of working capital, viz., inventories and debtors, that may be needed for a given scale and type of operation. Cash is, no doubt, a most important asset and that is why a firm wants to get hold of it in the shortest time possible. In the absence of sufficient quantity of cash at the proper time, payment of bills including dividend and others may not have to be made.
The firm’s needs for cash may be attributed to the following needs:
1. Transactions Reason
This reason refers to the holding of cash, to meet routine cash requirements in the ordinary course of business. A firm enters into a number of transactions which requires cash payment. For example, purchase of materials, payment of wages, salaries, taxes, interest etc. Similarly, a firm receives cash from cash sales, collections from debtors, return on investments etc. But the cash inflows and cash outflows do not perfectly synchronize. Sometimes, cash receipts are more than payments while at other times payments exceed receipts. The firm must have to maintain sufficient (funds) cash balance if the payments are more than receipts. Thus, the transactions reason refers to the holding of cash to meet expected obligations whose timing is not perfectly matched with cash receipts. Though, a large portion of cash held for transactions reason is in the form of cash, a part of it may be invested in marketable securities whose maturity conform to the timing of expected payments such as dividends, taxes etc.
2. Precautionary Reason
A firm is required to keep cash for meeting various contingencies. Though cash inflows and cash outflows are anticipated but there may be variations in these estimates. Such contingencies often arise in a business. A firm should keep some cash for such contingencies or it should be in a position to raise finances at a short period. The cash maintained for contingency needs is not productive or it remains idle. However, such cash may be invested in short-period or low-risk marketable securities which may provide cash as and when necessary.
Apart from the non-synchronization of expected cash receipts and payments in the ordinary course of business, a firm may be failed to pay cash for unexpected contingencies. For example, strikes, sudden increase in cost of raw materials etc. Cash held to meet these unforeseen situations is known as precautionary cash balance and it provides a caution against them. The amount of cash balance under precautionary reason is influenced by two factors i.e. predictability of cash flows and the availability of short term credit. The more unpredictable the cash flows, the greater the need for such cash balances and vice versa. If the firm can borrow at short-notice, it will need a relatively small balance to meet contingencies and vice versa. Usually precautionary cash balances are invested in marketable securities so that they contribute something to profitability.
3. Speculative Reason
The speculative reason relates to holding of cash for investing in profitable opportunities as and when they arise. Such opportunities do not come in a regular manner. These opportunities cannot be scientifically predicted. These transactions are speculative because prices may not move in a direction in which we suppose them to move. For example, if the firm expects that the material prices will fall, it can delay the purchases and make purchases in future when price actually declines. Similarly, with the hope of buying securities when the interest rate is expected to decline, the firm will hold cash. By and large, firms rarely hold cash for speculative purposes.
4. Compensation Reason
This reason to hold cash balances is to compensate banks and other financial institutes for providing certain services and loans. Banks provide a variety of services to business firms like clearance of cheques, drafts, transfer of funds etc. Banks charge a commission or fee for their services to the customers as indirect compensation. Customers are required to maintain a minimum cash balance at the bank. This balance cannot be used for transaction purposes. Banks can utilize the balances to earn a return to compensate their cost of services to the customers. Such balances are compensating balances. These balances are also required by some loan agreements between a bank and its customers. Banks require a chest to maintain a minimum cash balance in his account to compensate the bank when the supply of credit is restricted and interest rates are rising.
Thus cash is required to fulfill the above reasons. Out of the four reasons of holding cash balances, transaction reason and compensation reasons are very important. Business firms usually do not speculate and need not have speculative balances. The requirement of precautionary balances can be met out of short-term borrowings.