Motives for Holding Cash
Each and every firm needs cash for carrying out different activities like meeting its daily needs(e.g. paying salary, wages, due loans, purchase of raw materials, etc), maintaining a certain level of cash to face the unpredicted fluctuation in cash flows in the future, and holds cash to take advantages of price movement in the markets. Thus, there are mainly three motives for holding cash which is as follows:
- Transaction Motive
- Precautionary Motive
- Speculative Motive
Transaction motive refers to the need to hold cash to satisfy normal disbursement collection activities associated with a firm’s day to requirements. For e.g.cash for the purchase of goods, payment of salary, wages, rent, interest, tax, insurance, dividend, and so on.
A firm also receives cash in terms of sales revenue, interest on loans, return on investments made outside the firm, and so on. If these receipts and payments were perfectly synchronized, a firm would not have to hold cash for transaction motives. But in real, cash inflows and outflows cannot be matched exactly. Sometimes receipts of cash exceed the disbursement whereas at other times disbursement exceeds the receipt. Because of this reason, if disbursement exceeds the receipt, a firm should hold a certain level of cash to meet the current payment of cash in excess of its receipt during the period.
Precautionary motive refers to the need to hold cash as a safety margin to act as a financial reserve which may be required for the payment of unpredictable or unanticipated events in the future. For e.g. strikes and lock-ups from employees, increase in the cost of raw materials, funds, and labor, fall in market demand, and so on.
These emergencies also bound a firm to hold a certain level of cash. But how much cash is held against these emergencies depends on the degree of predictability associated with future cash flows. If there is a high degree of predictability, less cash balance is sufficient. Some firms may have strong borrowing capacity at very short notice so that they can borrow at the time when emergencies occur. Such a firm may hold the very minimum amount of cash for this motive.
Speculative motive refers to the need to hold cash in order to be able to take advantage of additional investment opportunities. For e.g, perhaps the company wants to acquire a competitor or a supplier and thinks they’ll have the chance soon. Or maybe management sees the opportunity to purchase raw materials or repurchase their stock at a significant discount.
The speculative motive for holding cash refers to the decision to keep cash on hand as a potential investment opportunity, rather than as a medium of exchange or for transaction purposes. Market or economic conditions that may increase investment opportunities, such as a decrease in asset prices or a rise in interest rates, may induce investors to hold cash. Unlike the transactional motive, where cash is held to pay bills or make purchases every day, the utility motive involves holding cash for a specific purpose.
Why is it important to hold cash as part of your investment portfolio?
a) Cash can provide liquidity in case of emergencies.
b) Cash allows you to take advantage of short-term market fluctuations.
c) Cash gives you the ability to make quick investments.
d) all of the above
Answer: d) all of the above
How does holding cash impact your risk level?
a) It increases your risk level.
b) It decreases your risk level.
c) It does not impact your risk level.
d) It depends on the amount of cash held.
Answer: b) It decreases your risk level.
Can holding cash limit your potential for growth?
a) Yes, it limits your potential for growth.
b) No, it does not limit your potential for growth.
c) It depends on the amount of cash held.
d) It depends on the market conditions.
Answer: a) Yes, it limits your potential for growth.
How much cash should be held as part of your investment portfolio?
a) It depends on your financial goals and risk tolerance.
b) As much as possible.
c) As little as possible.
d) A fixed percentage of your total investments.
Answer: a) It depends on your financial goals and risk tolerance.
Why is it important to regularly review your cash holdings as part of your investment portfolio?
a) To ensure that you have enough liquidity to cover emergencies.
b) To ensure that you are not missing out on potential investment opportunities.
c) To ensure that you are not over-allocated in cash.
d) All of the above.
Answer: d) All of the above.