Corporate Liquidity: Managing Cash & Short-Term Assets

The cash inflows (collections) and outflows (disbursements) are not perfectly synchronized, and some level of cash holdings is necessary to serve as a buffer. Perfect liquidity is the characteristic of cash that allows it to satisfy the transactions motive.

Determining the Target Cash Balance

The target cash balance involves a trade-off between the opportunity costs of holding too much cash (lost interest) and the trading costs of holding too little. If a firm tries to keep its cash holdings too low, it will find itself selling marketable securities more frequently than if the cash balance were higher. The trading costs will tend to fall as the cash balance becomes larger. The opportunity costs of holding cash rise as the cash holdings rise.

Investing Idle Cash

If a firm has a temporary cash surplus, it can invest in short-term securities. The market for short-term financial assets is called the money market. The maturity of short-term financial assets that trade in the money market is one year or less. Some large firms and many small firms use money market mutual funds. These are funds that invest in short-term financial assets for a management fee. The management fee is compensation for the professional expertise and diversification provided by the fund manager.

Firms have temporary cash surpluses for various reasons:

• Seasonal or Cyclical Activities: Some firms have a predictable cash flow pattern. They have surplus cash flows during part of the year and deficit cash flows the rest of the year.
• Planned or Possible Expenditures: Firms frequently accumulate temporary investments in marketable securities to provide the cash for a plant construction program, dividend payment, or other large expenditure.

Characteristics of Short-Term Securities

1. Maturity: Longer maturity securities are more exposed to interest rate risk than shorter maturity securities. Firms often limit their investments in marketable securities to those maturing in less than 90 days to avoid the risk of losses in value from changing interest rates.
2. Default Risk: It refers to the probability that interest and principal will not be paid in the promised amounts on the due dates.