In: Finance
What happens if you hold more cash reserves? It increases liquidity, but does it also increase equity or current liabilities? Or does it increase foregone profits? Thanks.
Question: What happens if you hold more cash reserves? It increases liquidity, but does it also increase equity or current liabilities? Or does it increase foregone profits? Thanks.
1) Cash Reserves: Cash reserves are the Cash and Cash equivalents in the Balance Sheet of the any entity. These are the balances which are required to be maintained as sufficient as possible to meet the business requirements. Sufficiency of this is very tricky in terms of quantity and its applicability.
Any business shall be two types of requirements - Capital expenditure and Revenue Expenditure. Capital spends include cash spent on major CAPEX or any other major requirements like business acquisitions etc. These are generally well planned spends and gives enough time for the company to pool the cash. Revenue expenditure is towards the operational expenses, working capital requirements, etc of the Business. While these are already in the cycle of the business, any sudden swings in the costs/Working Capital requirements to be immediately addressed by pumping in the money. Hence, liquidity is very important to be maintained to ensure that the Business shall not get impacted.
However, any money lying idle in the Balance Sheet is considered as misapplication. While liquidity is important, any excess liquidity should be used to generate more money/value for the company or reduce unwanted liabilities for the company. There are many modes through which this can be done:
- Investment approach: To look for various short term and long term investments such that the excess cash can be invested in to.
- Capital Budgeting: To look for any opportunities for CAPEX spent such that there shall be any Capacity increase or Process improvements for the company. This is for the Business expansions, value creation, Margin improvements, etc;
- Liability reduction: To look for retirement of Debt obligations which are stress on the Balance Sheet. To look for optimisation of current liabilities by paying to the level of credit limits available with them; This shall increase the supplier confidence and can benefit operationally.
- Share Buyback: This is one of the ways to reward the Shareholders and equally to add value to the Business/company. Reduction of the equity thru buy back shall limit the equity and value per equity increases significantly.
2) More Cash Reserves doesn’t mean that the increase in Equity or Liabilities; However, as mentioned above, these excess cash reserves can be used for reduction of the equity or liabilities;
3) Does it increase foregone profits?: The correlation between the excess cash reserves and the foregone profits is explained above. In fact, if the excess cash reserves kept idle for an amount of time, results in increase in the level of foregone profits. Hence, the excess liquidity should always be applied properly through any of the mentioned modes above.