WCM/U2 Topic 9 Reasons for Holding Marketable Securities
Transaction motives require a firm to hold cash to conduct its business in elite ordinary course. The firm needs cash primarily to make payments for purchases, wages, operating expenses, taxes, dividends, etc. The need to hold cash would not arise if there were perfect synchronization between cash receipts and cash payment i.e. enough cash is received when the payment has to be made. But cash receipt and payments are not perfectly synchronized. Sometimes cash receipts exceed cash payments, while at another times cash payment are more than cash receipts. For those periods when cash payments exceed cash receipts, the firm should maintain some cash balance to be able to make the required payments. For transactions purpose, a firm will purchase the securities whose maturity corresponds with some anticipated payments, such as dividends, taxes etc., in future. However, the transactions motive mainly refers to holding cash to meet anticipated payment whose timing is not perfectly matched with cash receipts.
The precautionary motive is the need to hold cash to meet any contingencies in future. It provides a cushion or buffer to withstand some unexpected emergency. The precautionary amount of cash to be kept depends upon the predictability of cash flows. If cash flows can be predicted with accuracy, less cash will be maintained against an emergency. The amount of precautionary cash is also influenced by the firm’s ability to borrow at short notice, when the need arises. Stronger ability of the firm to borrow at short notice lessens the need for precautionary balance.
The precautionary balance may be kept in cash and marketable securities. Marketable securities play an important role here. The amount of cash set aside for precautionary reasons is not expected to earn anything, therefore, the firm should attempt to earn some profit on it. Such funds should be invested in high liquid and low-risk marketable securities. Precautionary balances should, thus, be held more in marketable securities and relatively less in cash.
The Speculative Motives:
The speculative motive relates to the holding of cash for investing in profit making opportunities as and when they arise. The opportunity to make profit may arise when the security prices changes. The firm will hold cash, when it is expected that interest rates will fall. Securities can be purchased when the interest rate is expected to fall. The firm will benefit by the subsequent fall in interest rates and increase in security prices. The firm may also speculate on materials prices. If it is expected that materials price will fall, the firm can postpone materials purchasing and make purchases in future when price actually falls. Some firms may hold cash for speculative purposes. By and large, business firms do not engage in speculations. Thus, the primary motives to hold cash and marketable securities are the transactions motive and the precautionary motive.
Advantages/benefits of marketable securities:
Investment in marketable securities provide the following additional advantages:
(1) Interest and Dividend Revenue
Marketable securities earn dividend or interest revenue for the company. If a company holds a large sum of cash and does not invest it anywhere, it will generate nothing for the company.
(2) Increase in Market Value:
Marketable securities also generate a return when their market value increases.
Unlike long term investments, purchase of marketable securities does not impact the liquidity position of the business. They can be quickly sold in the secondary financial markets to meet immediate cash needs of the company.