Transactions Motive For Holding Cash

Published Date: 02 Nov 2017

Working capital management refers to management of current assets and current liabilities. It is regarded as the main part of a firm’s short-term financial planning because it involves the management of cash, inventory and accounts receivable (Van Horne, J. 1995). The ways that these three components are managed determine some of a company’s most important financial ratios which are the ‘inventory turnover’, the ‘average receivables collection period’ and the ‘quick ratio’ (Weston, J. & Copeland, T. 1986). Consequently, working capital management reflects a firm’s short- term financial performance. Weston & Copeland (1986) argued that working capital management is very essential especially for small firms. This is so because most small firms’ large amount of current liabilities resulting from restricted access to long-term capital. In the following, the three components of working capital management that is, the cash management, the inventory management, and the credit management will be discussed. In financial annual reports, working capital is defined in an algebraic expression as follows:

Net Working Capital (NWC) = Current Assets (CA) – Current Liabilities (CL).

Cash Management

According to Weston and Copeland (1986), cash management has emerged from "the relatively high level of interest rates on short-term investments has raised the opportunity cost of holding cash". Van Horne states that "cash management involves managing the money of the firm in order to maximize cash availability and interest income on any idle funds". In order to achieve this, cash management encompasses the following functions, as established by Van Horne: managing collections, control of disbursements, electronic funds transfers, balancing cash and marketable securities and investment in marketable securities. Cash budgeting - although not being a part of cash management but rather an element of short-term planning (Van Horne, 1995) - constitutes the starting-point for all cash management activities as it represents the forecast of cash in- and outflows and therefore reflects the firm’s expected availability and need for cash.

In the following, merely the element of cash management which deals with the problem of determining the optimal investment in cash shall be discussed. For this purpose a cash management model which is based on the EOQ model will be presented. It should be noted that for this purpose, a distinction between cash and cash equivalents, i.e. marketable securities is crucial. Similarly to the previous section on inventory decisions, merely the first step, i.e. the decision on the optimal cash level, i.e. the balance between cash and marketable securities, will be treated. The other functions of cash management are not of significance for the achievement of this work’s objective and a discussion of these would go beyond its scope.

Keynesian Motive for Holding Cash

In his influential work "The General Theory of Employment, Interest and Money" first published in the year 1936, John Maynard Keynes devotes one chapter to "The Psychological and Business Incentives to Liquidity" in which he elaborates on the motives for holding cash. Keynes, J. (1973), "The collected writings of John Maynard Keynes- vol. 7: With the general theory of employment, interest and money" he distinguishes between three different but interrelated motives: The ‘transactions-motive’, the ‘precautionary-motive’ and the ‘speculative-motive’.

Transactions Motive for Holding Cash

The ‘transactions-motive’ deals with bridging the gap between cash collections and disbursements. In other words, it refers to "the receipt and payment of cash". In this regard, Keynes differentiates between the ‘income-motive’ and the ‘business-motive’ which are subordinate motives to the ‘transactions-motive’ (Keynes, J. 1973). Both motives are based on a very similar principle but while the ‘income-motive’ deals with an individual’s cash holding behaviour, the ‘business-motive’ describes an enterprise’s motives. For the purpose of this work, only the latter is of importance. According to Keynes (1973), companies hold cash in order to "bridge the interval between the time of incurring business costs and that of the receipt of the sale-proceeds". In other words: Companies hold a certain amount of cash in order to meet the regular expenses of their activity. Therefore, the higher the firm’s ability to schedule its cash flows - depending on their predictability - the weaker the ‘transactions-motive’ for holding cash will be.( Weston, J. & Copeland, T. 1986).

The Precautionary-Motive

Keynes’ second motive, the ‘precautionary-motive’, pays regard to a company’s need to provide for unsuspected expenses and "unforeseen opportunities of advantageous purchases" (Keynes, J. 1973). The strength of the ‘precautionary-motive’ is determined by the risk of a sudden contingency and the probability of a profitable acquisition. Thus, if a firm operates in a highly volatile sector of activity, its precautionary cash holding will be higher than that of firms which act in a less risky environment.

The Speculative-Motive

Keynes’ third motive refers to the holding of cash for the purpose of speculation. The ‘speculative-motive’ is based on the assumption that rising interest rates induce decreasing prices of securities and vice versa. Therefore, a firm will invest its idle cash in securities when interests are expected to decrease. Van Horne (1995) claims that companies do not hold cash for this kind of speculative purpose and it can be assumed that this estimation is valid especially for SMEs which usually do not have resources to make such complex financial decisions. Therefore the significance of Keynes’ ‘speculative-motive’ is negligible for this work.

Strength of the Keynesian Motives

The transactions and precautionary motives share one common ground. Their strength is dependent on the accessibility of cash and the cost of acquiring it when needed (Keynes, J. 1973) Costs of running out of cash, i.e. shortage costs are therefore an important factor which influences the strength of the first two Keynesian motives. In the extreme case of maximum ease of access and no costs associated i.e. no shortage costs of running out of cash, a company would not hold any cash at all. In the event of an emerging expense, it would simply retrieve the required amount from its portfolio of short-term investments.

Additionally, a firm’s demand for cash depends on the "relative cost" of holding cash. In this context, Keynes mentions the example of "forgoing the purchase of a profitable asset" in order to be able to hold on to a certain amount of cash. This ‘relative cost’ will weaken the firm’s motive for holding cash and lead to a lower cash holding in order for the company to be able to make profitable acquisitions when these occur.

Yet, another factor which strengthens the two first Keynesian motives is the aspect of bank charges which could be avoided by holding cash. Obviously, if reducing bank deposits diminishes the associated costs, firms will tend to hold a larger amount of cash.

Relevance of the Keynesian motives

The Keynesian motives for holding cash are frequently referred to and further developed or slightly modified in relevant literature. In their discussion on firms’ reasons for holding cash and marketable securities, Weston & Copeland add two further motives to the Keynesian ‘transactions’ and ‘precautionary’ motives. They claim that the level of liquid funds, i.e. cash plus marketable securities, will rise significantly if a firm is envisaging important investments in the near future. The second reason for holding cash that the authors include is "compensating balance requirements" which refers to the minimum balance that a bank requests its professional customers to preserve in their current account. This aspect is not an inherent motive but rather an extrinsic obligation which serves as an assurance to the bank. In this regard, the compensating balance is also mentioned by Ross et al. as one of the authors’ two main reasons for cash holding, the other one being the ‘transactions-motive’.

Keynes’ motives are a very widespread approach in financial theory in order to explain cash holding behaviours of companies and they also constitute the basis for a great deal of cash management models which will be discussed later on. As already pointed out, the third motive is irrelevant when studying the cash holding behaviour of SMEs because of its complexity. However, the ‘transactions-motive’ and ‘precautionary-motive’ represents a very basic approach to illustrating the cash holding behaviour of firms. Therefore, they should be particularly applicable to SMEs, with the assumption that SMEs manage their funds using less complex methods compared to large firms.

Receivable management

Businesses have either products or services to sell to their customers; they also want to maximize their sales. So, in order to increase the level of their sales they use different policies to attract customers and one of them is offering a trade credit. Trade credit basically refers to a situation where a company sells its product now to receive the payment at a specified date in the future. Fabozzi and Peterson (2003 p. 651) mentioned that when a firm allows customers to pay for goods and services at a later date, it creates accounts receivable or refers to trade credit. Account receivables (trade credit) also have opportunity cost associated with them, because company can’t invest this money elsewhere until and unless it collects its receivables. More account receivables can raise the profit by increasing the sale but it is also possible that because of high opportunity cost of invested money in account receivables and bad debts the effect of this change might turn difficult to realize. Hence, it calls for careful analysis and proper management is compulsory task of company’s credit managers. Therefore, the goal of receivables management is to maximize the value of the firm by achieving a tradeoff between risk and profitability. For this purpose, the finance manager has to obtain optimum (non-maximum) value of sales, control the cost of receivables, cost of collection, administrative expenses, bad debts and opportunity cost of funds blocked in the receivables. Further, financial manager has to maintain the debtors at minimum according to the credit policy offered to customers, offer cash discounts suitably depending on the cost of receivables and opportunity cost of funds blocked in the receivables (Gallagher and Joseph, 2000). Indeed trade credit management has to look through cost and benefit analysis including credit and collection policies of companies in maintaining receivable.

Inventory Management

The inventory of a firm that is into manufacturing can be divided into three groups: ‘raw materials’, ‘work -in- progress’ and ‘finished goods’. Raw material refers to input the firm uses to start up its production. The second type of inventory is work-in-progress. This inventory refers to production yet to be completed. This type of inventory arises as a result of the length of production. The third type of inventory is finished goods. They represent the end product of the manufacturing process (Ross et al 2008). The other two types of inventory, however, are not unavoidable and therefore they are subject to the company’s decision. It should be noted that inventory size is obviously not completely in the firm’s sphere of influence but rather considerably determined by its output and by the product’s manufacturing process and attributes. Thus, the average level of inventory can vary significantly between different industry sectors. However, the conveniences and disadvantages of relatively large inventories are always similar: Large inventories allow the company to meet customers’ demands and purchase economically preventing stock-out cost and taking advantage of decreased ordering costs. The firm’s enhanced flexibility thus is the main advantage of large inventory. The downside of large inventory comprises several aspects. Besides the apparent cost of handling and storage, there is also the relative cost of Capital tie-up and the threat of obsolescence. In this regard, the decision maker’s task is to strike a balance between the above mentioned benefits and costs of inventory in order to find the optimal inventory size.

Economic Order Quantity

The ‘Economic Order Quantity’ (EOQ) model is a simple concept used in determining a company’s optimal inventory level and order size is introduced. An understanding of the EOQ model will therefore facilitate the comprehension of the cash management model as well as the basic issue of working capital management. In order to stay within the scope of this study, only the first step, namely the decision on inventory level, shall be examined. The second stage which deals with order size and inventory usage is not of importance for the achievement of this paper’s purpose.

Optimal Inventory Size

The EOQ model can be applied to all kinds of inventory, i.e. raw materials; work in progress as well as finished goods (Van Horne, 1995). In order to ensure the applicability of the EOQ model, several assumptions must be taken into consideration. First, the usage of the stored product is assumed to be steady. Second, ordering costs are assumed to be constant, i.e. the same amount has to be paid for any order size. Finally, the carrying costs of inventory which are composed of costs of storage, handling and insurance "are assumed to be constant per unit of inventory, per unit of time". The EOQ model in its simplest conception therefore merely takes variable costs into consideration, (Weston, & Copeland, 1986), although it can easily be extended so as to include fixed costs.

Significance of the Inventory Model

The EOQ model is a very simple approach and it certainly has strict limitations as many more related costs could be imagined, but it exemplifies the trade-off between the risk of running out of inventory and the profits earned by keeping the level of inventory low and thus minimizing its costs. As will be shown later on, this trade-off between risk and earnings is common to all three components of working capital management. Therefore, the basics of the EOQ model can be applied to all current assets.

Account Payable Management

Gitman (2009) and Birt et al., (2011) state that Accounts Payable Management objective is to pay creditors as slowly as possible without damaging its credit rating. Accounts Payable and accruals are the two major spontaneous liability sources of short-term financing for a typical firm. Accounts Payables are the major unsecured short-term financing for businesses. They result from transactions in which merchandise (inventory) is purchased. The suppliers might give credit terms together with allowing discount to the purchasers.

Average Payment Period (APP):

The Average Payment Period (APP) is the final component of the cash conversion cycle (CCC), which has two parts in it. Firstly, the time from the purchase of the raw materials until the payments is mailed to the suppliers. Secondly, the payment floats time (Birt et al., 2011; Cinnamon et al., 2010; Gitman, 2009).