Question

What influences might affect the size of a firm’s cash buffer? why a firm with low cash reserve might have difficulty obtaining a loan

Answer 1

Solution:

Cash buffers are the funds that companies set aside for use during contingency of emergency situations. Cash buffer plays in important role in company’s balance sheet. This is vital for a company to maintain optimal level of cash buffer to use during contingency. Cash buffers needs to be maintained at an optimal level sufficient enough to cover fixed expenses of the company for a reasonable period of time.

This would cover unexpected or unforeseen costs and provide financial cushion at the time of revenue losses. Cash buffer created over time through surplus cash generated by business and keeping a portion aside would also help to finance expansion through capital reinvestment.

Instruments that are useful maintaining cash buffer/liquidity:

1. Short-term deposits with bank or in debt mutual funds.

2. Investment in money market funds and Treasury Bills etc.

Companies with sufficient liquidity are preferable options for financial institutes to lend money since it ensures regular debt payments. Some financial institutes may offer loans based on liquid assets of the company. This would allow companies to obtain additional capital without selling their liquid assets, and allowing these existing assets to continue to generate passive income and assist increasing their capital base.

Key advantages for optimal level of cash buffers are:

A. Financial cushion against unexpected costs

At the time of emergencies liquid assets would offer immediate financial cushion. On the other hand, non-liquid assets, such as real estate etc. may not be liquidated immediately to pay the short term requirement.

B. Offer investment opportunity

Cash buffer can also be used to invest and build new investment portfolio at the optimal time withough needing to sell the existing investments.

C. Mitigating risks

Optimal level of cash buffer carries lower risk at the time of market uncertainty such as financial crises. At such times selling non-liquid assets would be daunting tasks. However value of cash buffer remains intact and offer sustainability for its business operations.

D. Healthy Financial Profile

Optimal cash buffer would increase chances of loan approval by financial institutes as it shows that company has discipline to keep cash aside and is more likely to make timely payments for its debt.