cash flow, and value. The following sections discuss the individual components of
NOWC.Identify and explain three alternative working capital policies.
What are the principal components of net operating working capital?
What are the reasons for not wanting to hold too little working capital? For not
wanting to hold too much?Cash Management
Approximately 1.5 percent of the average industrial firm’s assets are held in the
form of cash, which is defined as demand deposits plus currency. Cash is often
called a “nonearning asset.” It is needed to pay for labor and raw materials, to buy
fixed assets, to pay taxes, to service debt, to pay dividends, and so on. However,
cash itself (and also most commercial checking accounts) earns no interest. Thus,
the goal of the cash manager is to minimize the amount of cash the firm must hold
for use in conducting its normal business activities, yet, at the same time, to have
sufficient cash (1) to take trade discounts, (2) to maintain its credit rating, and (3) to
meet unexpected cash needs. We begin our analysis with a discussion of the reasons
for holding cash.Reasons for Holding Cash
Firms hold cash for two primary reasons:
1.Transactions.Cash balances are necessary in business operations. Payments must be
made in cash, and receipts are deposited in the cash account. Cash balances associ-
ated with routine payments and collections are known as transactions balances.
Cash inflows and outflows are unpredictable, with the degree of predictability vary-
ing among firms and industries. Therefore, firms need to hold some cash in reserve
for random, unforeseen fluctuations in inflows and outflows. These “safety stocks”
are calledprecautionary balances,and the less predictable the firm’s cash flows,
the larger such balances should be.
2.Compensation to banks for providing loans and services.A bank makes money by lend-
ing out funds that have been deposited with it, so the larger its deposits, the bet-
ter the bank’s profit position. If a bank is providing services to a customer, it may
require the customer to leave a minimum balance on deposit to help offset the
costs of providing the services. Also, banks may require borrowers to hold de-
posits at the bank. Both types of deposits are defined as compensating balances.
In a 1979 survey, 84.7 percent of responding companies reported that they were
required to maintain compensating balances to help pay for bank services.^5 Only
13.3 percent reported paying direct fees for banking services. By 1996 those find-
ings were reversed: only 28 percent paid for bank services with compensating
balances, while 83 percent paid direct fees.^6 So, while the use of compensating
balances to pay for services has declined, it is still a reason some companies hold
so much cash.(^5) See Lawrence J. Gitman, E. A. Moses, and I. T. White, “An Assessment of Corporate Cash Management
Practices,” Financial Management,Vol. 14, no. 1, Spring 1979, 32–41.
(^6) See Charles E. Maxwell, Lawrence J. Gitman, and Stephanie A. M. Smith, “Working Capital Management
and Financial-Service Consumption Preferences of US and Foreign Firms: A Comparison of 1979 and 1996
Preferences,” Financial Practice and Education,Fall/Winter 1998, 46–52.
Cash Management 587