306 Corporate Finance
WHY DO FIRMS HOLD CASH?
In General Theory of Employment, Interest and Money, John Maynard Keynes wrote, ‘There is no necessity
to hold idle cash to bridge over intervals if it can be obtained without difficulty at the moment when it is ac-
tually required.’ Yet, we do not see it in actual practice. Companies continue to hold cash (see Exhibit 16.1).
Exhibit 16.1 Corporate cash holdings in 2001
(Rs crore)
Company Cash in hand Bank balance Total
HLL 913.15 1.41 914.56
Infosys 0.01 385.05 385.06
Reliance Industries 1.30 99.33 100.63
TELCO 0.96 114.50 115.46
TISCO 128.68 111.10 239.78
Colgate Palmolive 0.13 74.93 75.06
P&G Hygiene 0.03 48.61 48.64
Source: Prowess.
In the case of a perfect market it does not matter whether the firm retains the cash or disburses it to shareholders
through dividends or cuts debt, since there is no difference between cash inside the firm and that outside.
When markets are not perfect, cash inside and outside are not equivalent. One of the most commonly cited
reasons for holding cash is the transaction motive. A firm may hold cash to enable it to fund projects if the
cash flow in that period is low. The company may raise external finance if available. This is not possible for
firms that face information asymmetry or agency costs. A cash reserve would enable the company to tide
over the deficit. In other words, firms that have volatile cash flow are more likely to hold greater amounts of
cash. Likewise, those firms subject to higher distress costs may hold greater amounts of cash to act as a
buffer. The length of the cash conversion cycle also determines the amount of cash a company holds. Firms
with relatively shorter cash conversion cycles are likely to hold less liquid assets. Other determinants of
scope and nature of cash management in an organization include:
- Size of the company,
- Extent of decentralization of operations, and
- Geographical scope.
Size Larger companies can justify the cash management efforts by the magnitude of savings whereas
smaller companies cannot. Larger companies, almost by definition, have larger cash flows to track, have
greater number of bank relationships. This calls for sophisticated cash management practice. This is especially
true of businesses that are cash intensive. For instance, the need to hold cash is more in companies that sell
through retail outlets such as FMCG companies than in those that sell on a wholesale basis.
Extent of Decentralization If the company has a decentralized structure, it might delegate at least a part
of the cash management responsibility to the operating units. In many companies, the corporate treasury
function is restricted to headquarters with minimal freedom given to divisional counterparts. The headquarters
may exercise control on short-term investing and borrowing activities whereas divisions may be responsible
for cash flow they generate. This type of allocation of responsibilities leads to sub optimization of efforts.
The philosophy is to let someone do what one is good at. This is not an easy process. At times, centralization
of key activities leads to heartburn.