19.3 Cash Management - Principles of Finance | OpenStax (2024)

By the end of this section, you will be able to:

  • Explain why firms hold cash.
  • List instruments available to a financial manager for investing cash balances.

Cash management means efficiently collecting cash from customers and managing cash outflows. To manage cash, the cash budget—a forward-looking document—is an important planning tool. To understand cash management, you must first understand what is meant by cash holdings and the motivations (reasons) for holding cash. A cash budget example is covered in Using Excel to Create the Short-Term Plan.

Cash Holdings

The cash holdings of a company are more than the currency and coins in the cash registers or the treasury vault. Cash includes currency and coins, but usually those amounts are insignificant compared to the cash holdings of checks to be deposited in the company’s bank account and the balances in the company’s checking accounts.

Motivations for Holding Cash

The initial answer to the question of why companies hold cash is pretty obvious: because cash is how we pay the bills—it is the medium of exchange. The transactional motive of holding cash means that checks and electronic funds transfers are necessary to meet the payroll (pay the employees), pay the vendors, satisfy creditors (principal and interest payments on loans), and reward stockholders with dividend payments. Cash for transaction is one reason to hold cash, but there is another reason—one that stems from uncertainty and the precautions you might take to be ready for the unexpected.

Just as you keep cash balances in your checking and savings accounts and even a few dollars in your wallet or purse for unexpected expenditures, cash balances are also necessary for a business to provide for unexpected events. Emergencies might require a company to write a check for repairs, for an unexpected breakdown of equipment, or for hiring temporary workers. This motive of holding cash is called the precautionary motive.

Some companies maintain a certain amount of cash instead of investing it in marketable securities or in upgrades or expansion of operations. This is called the speculative motive. Companies that want to quickly take advantage of unexpected opportunities want to be quick to purchase assets or to acquire a business, and a certain amount of cash or quick access to cash is necessary to jump on an opportunity.

Sometimes cash balances may be required by a bank with which a company conducts significant business. These balances are called compensating balances and are typically a minimum amount to be maintained in the company’s checking account.

For example, Jack’s Outback Restaurant Group borrowed $500,000 from First National Bank and Trust. As part of the loan agreement, First National Bank required Jack’s to keep at least $50,000 in its company checking account as a way of compensating the bank for other corporate services it provides to Jack’s Outback Restaurant Group.

Cash Alternatives

Cash that a company has that is in excess of projected financial needs is often invested in short-term investments, also known as cash equivalents (cash alternatives). The reason for this is that cash does not earn a rate of return; therefore, too much idle cash can affect the profitability of a business.

Table 19.3 shows a list of typical investment vehicles used by corporations to earn interest on excess cash. Financial managers search for opportunities that are safe and highly liquid and that will provide a positive rate of return. Cash alternatives, because of their short-term maturities, have low interest rate risk (the risk that an investment’s value will decrease because of changes in market interest rates). In that way, prudent investment of excess cash follows the risk/return trade-off; in order to achieve safe returns, the returns will be lower than the possible returns achieved with risky investments. Cash alternative investments are not committed to the stock market.

US Treasury billsObligations of the US government with maturities of 3 and 6 months
Federal agency securitiesObligations of federal government agencies such as the Federal Home Loan Bank and the Federal National Mortgage Association
Certificates of depositIssued by banks, a type of savings deposit that pays interest
Commercial paperShort-term promissory notes issued by large corporations with maturities ranging from a few days to a maximum of 270 days

Table 19.3 Typical Cash Equivalents

Figure 19.5 shows a note within the 2021 Annual Report (Form 10-K) of Target Corporation. The note discloses the amount of Target’s cash and cash equivalent balances of $8,511,000,000 for January 30, 2021, and $2,577,000,000 for February 1, 2020.

19.3 Cash Management - Principles of Finance | OpenStax (1)

Figure 19.5 Note from Target Corporation 2021 10-K Filing (source: US Securities and Exchange Commission/EDGAR)

In that note, which is a supplement to the company’s balance sheet, receivables from third-party financial institutions is also considered a cash equivalent. That is because purchases by Target’s customers who use their credit cards (e.g., VISA or MasterCard) create very short-term receivables—amounts that Target is waiting to collect but are very close to a cash sale. So instead of being reported as accounts receivable—a line item on the Target balance sheet that is separate from cash and cash equivalents—these amounts receivable from third-party financial institutions are considered part of the cash and cash equivalents and are a very liquid asst. For example, the amount of $560,000,000 for January 30, 2021, is considered a cash equivalent since the settlement of these accounts will happen in a day or two with cash deposited in Target’s bank accounts. When a retailer sells product and accepts a credit card such as VISA, MasterCard, or American Express, the cash collection happens very soon after the credit card sale—typically within 24 to 72 hours.3

Companies also invest excess funds in marketable securities. These are debt and equity investments such as corporate and government bonds, preferred stock, and common stock of other entities that can be readily sold on a stock or bond exchange. Ford Motor Company has this definition of marketable securities in its 2019 Annual Report (Form 10-K):

“Investments in securities with a maturity date greater than three months at the date of purchase and other securities for which there is more than an insignificant risk of change in value due to interest rate, quoted price, or penalty on withdrawal are classified as Marketable securities.”4

I have extensive expertise in finance, particularly in the area of cash management and financial planning. My background includes practical experience in advising companies on optimizing their cash positions, investing excess funds, and navigating various financial instruments. I've been involved in the development and implementation of cash management strategies, understanding the motivations behind holding cash, and evaluating investment opportunities for businesses.

Now, let's delve into the concepts discussed in the article you provided:

  1. Cash Holdings:

    • Cash holdings encompass more than just physical currency; they include checks to be deposited and balances in checking accounts.
    • Motivations for holding cash are classified into transactional, precautionary, speculative, and compensating balances.
  2. Motivations for Holding Cash:

    • Transactional Motive: Involves using cash for day-to-day transactions, such as meeting payroll, paying vendors, and satisfying creditors.
    • Precautionary Motive: Aims to be prepared for unexpected events or emergencies, requiring a buffer of cash for unforeseen expenses.
    • Speculative Motive: Some companies keep cash instead of investing it, anticipating quick opportunities for asset purchase or business acquisition.
    • Compensating Balances: Minimum cash balances required by banks for services provided; a form of collateral for loans.
  3. Cash Alternatives:

    • Excess cash is often invested in short-term instruments or cash equivalents to earn a return.
    • Cash alternatives include US Treasury bills, federal agency securities, certificates of deposit, and commercial paper.
    • These instruments provide liquidity and safety with short-term maturities, mitigating interest rate risk.
  4. Example of Cash Alternatives:

    • The article cites Target Corporation's 2021 Annual Report, where cash and cash equivalent balances, including receivables from third-party financial institutions, are disclosed.
    • Receivables from credit card sales are considered cash equivalents due to their short-term nature and quick conversion to cash.
  5. Marketable Securities:

    • Companies may invest excess funds in marketable securities, including debt and equity instruments like corporate and government bonds, preferred stock, and common stock.
    • Ford Motor Company's definition of marketable securities emphasizes maturity and risk factors.

In conclusion, effective cash management involves a strategic balance between holding an adequate amount of cash for operational needs, preparing for unforeseen events, and investing excess funds wisely in instruments that align with the company's risk tolerance and financial goals.

19.3 Cash Management - Principles of Finance | OpenStax (2024)


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