Question

True or false? Not all excess cash should be invested in higher earning assets; although this reduces return on the cash, it also reduces costs that arise from not having cash on hand (such as late fees). Explain your answer.

Answer 1

The given statement is TRUE.

Explanation -

An entity should not invest entire excess cash avaiable in higher earning assets because investing in them might give higher returns but it also brings a few risks to the entity.

Not investing entire excess cash avaiable in higher earning assets may reduce the earnings earned on the such excess funds but it brings few added advantages to the entity.

Following costs can arise if an entity dosen't have sufficient cash in hand -

1) Payment of taxes and other statutory dues - If the entity invests have entire cash available, then it will not have funds to pay for government taxes and other statutory payments which may lead to heavy fines and penalties and sometimes prosecution also.

2) Loss of business opportunities - Sometimes a business comes across various good business opportunities such as heavy discount provided by the supplier if payment is made in cash, a machinery is available at a relatively cheap price, etc.

Entity will not be able to avail all these business opportunities if it dosen't have sufficient cash.

3) Higher earning Opportunity available later on - Suppose entire cash is invested in some assets initially and after sometime entity finds even more high earning assets, then the enity would not have funds to invest in the new asset.

So, altough not investing entire cash in high earning assets may result in reduced return on the cash but it can save the business from above mentioned costs.