The following points highlight the five main motives for holding cash balances in a firm. The motives are: 1. Transaction Motive 2. Precautionary Motive 3. Speculative Motive 4. Future Requirements 5. Compensating Balances.
1. Transaction Motive:
Cash balance is required to meet the day to day transactions of business. Firms hold cash for making necessary payments for goods and services they acquire. The cash inflows and outflows of day-to-day operations of a firm are not perfectly synchronized, and hence liquid asset balances are necessary to serve a buffer between these flows, to meet the fluctuations in cashflows.
As a general principle of cash management, working capital inflows should be more than working capital outflows at any point of time. The non-working capital cash inflows like capital receipts should be utilized for non-working capital outflows like purchase of fixed assets. The working capital inflows should always be in surplus over working capital outflows.
2. Precautionary Motive:
Firms hold cash to meet uncertainties, emergencies, running out of cash and fluctuations in cash balances. The holding of cash on these reasons are on precaution. The future cashflows and the ability to borrow additional funds at short notice are often uncertain. Sometimes, uncertainty can result in prolongation or disruption of operating cycle. This requires to carry additional cash balances as a precautionary motive.
3. Speculative Motive:
Sometimes, firm hold high cash balances over the precautionary level of cash balance to take advantage of speculative investment opportunities, to exploit discounts for prompt payments, to improve credit rating etc. Cash surplus companies can acquire the cash starved companies at least cost of acquisition. The company with excessive cash surplus can take steps to improve production and sales ultimately the profitability of the company improves.
Some firms who can efficiently manage cash surplus, can seek to deploy surplus cash in short-term marketable investments and money market instruments to get better returns. But it is to be kept in view that idle cash will attract opportunity cost. Purchase of readily marketable securities will enable to earn return on investment, as well as, to maintain the liquidity of the company.
4. Future Requirements:
The cash balances are held to meet future payment obligations like payment of tax, payment of dividend, purchase of fixed asset, redemption of debentures, repayment of term loan, buy-back of shares etc.
5. Compensating Balances:
A firm generally has to hold cash balances to compensate its banker for the services provided.