Motives for Holding Cash. One of the most important constituents of current assets is “cash.” It is required to carry out all the activities of the business. A business should have enough cash on hand to pay its bills right now and in the future. Cash, being totally unproductive by nature, should be kept at an optimum level.
Any shortage will adversely affect the business, and the surplus will be unproductive. Other current assets, like stock, investments, etc., will increase the wealth of the firm, but excess cash balances are unproductive. Cash, to a larger extent, includes cash equivalents like currency notes, cheques, bank drafts, and other marketable securities held with banks.
There are two aspects of “cash.” In the narrow aspect, it only includes the currency notes and the coins, whereas, in a broader aspect, it includes its equivalents like marketable securities, bank deposits, or other instruments that are highly liquid.
Cash can also be termed as the balancing factor between debtors, stockholders, and creditors. Adequate cash balances help to meet the working capital requirements and timely discharge of debts.
Motives for Holding Cash
The following are the motives for holding cash:
1) Transaction Motive:
A firm enters into a number of transactions every day. These are to be settled in terms of cash and these constitute the ordinary course of the business. A firm has to daily deal with the purchase of goods and services and the payment of the various expenses like rent, electricity, salary, wages, etc. These activities create liability and in order to discharge this obligation, cash is required.
The balance of cash is created by virtue of cash sale of goods and services, remittance from the debtors, and other revenue-generating options. The receipt and the payment of cash should be adequately managed so as to keep an adequate balance of cash which is a tough job to do. Sometimes the receipts exceed payments and sometimes they might fall short. For this non-matching of the inflow and the outflow certain volume of cash should be kept to stabilize the mechanism.
2) Precautionary Motive:
To meet adverse situations, some cash is kept in reserve as a precautionary tool. In routine business, there may be situations that are difficult to predict but are to be dealt with. These may be strikes, lockouts, high rates of wages and materials, unforeseeable loss, etc., which may cause an immediate requirement of cash. All these situations demand the outflow of cash, which must be predicted to keep adequate balances.
If the level of prediction is high, less volume of cash is to be maintained. Firms that have a high credit rating do not keep a high level of cash balances, as borrowing is available for such firms during emergencies.
3) Speculative Motive:
Under this motive, a sufficient balance of cash is kept to take the advantage of the market conditions, i.e., discounts at the time of the cash purchases, foreign exchange rate fluctuations, interest rate discounts, etc. An adequate cash balance puts the firm in a better bargaining position. A certain balance of cash is also maintained for speculation purposes. It involves holding cash to exploit the opportunities arising in the normal course of the business like fall in material prices, low-interest rates, high cash discounts, etc.
4) Compensation Motive/Compensating Balances:
Cash balances are also required to fulfill the compensating balance obligations. We receive certain services from banks for which we are not charged directly; rather the firm is required to keep some minimum balance in their account. This cash is kept as an idle balance on which no interest is given by the bank.
For example, certain banks require to maintain a minimum balance of 5,000 or 10,000 in a current account. This balance of cash maintained in the bank is known as the compensating balance. If the same balance is used by the firm to discharge its obligation, a certain amount of interest is charged by the bank.
Factors Affecting the Level of Cash– Click here