Liquidity of Cash and Short-Term Investments - Literature review Example

LIQUIDITY OF CASH AND SHORT-TIME INVESTMENTS By Student’s Name Code + Name of Course Professor/Tutor Institution City/State Date Liquidity of Cash and Short-Term Investments Cash is one of the liquid assets held by businesses (Hoshi, Kashyap & Scharfstein 1991:34). The cash at the businesses’ disposal can be used to obtain almost anything. Most stocks traded on the main exchanges are consideredliquidbecause they can be converted into cash easily and quickly. From a financial perspective, the topic on a firm holding liquidity cash is for it to gain more access to its investments. As such, holding liquid cash enables any business to eliminate the requirement for redeeming and the time for the cash to arrive into its account or disposal. Liquid cash can therefore enable a business to engage in short-term investment strategies within a long-term, well-diversified plan as the key to dealing with its financial requirements as they occur. According to Opler et al. (1999:6), the issue of holding liquid cash or short-term investments could connote anything from several months to years. Short-term investments portray either low yields or high risks to businesses, depending on where they put their money. The concept is also looked as an important way of generating more profit from businesses’ liquid savings or cash savings. This essay will look at the reasons why a firm might make short-time investments or liquid assets. The essay will also look at several criticisms against holding onto liquid cash or making short-term investments by reviewing different literature connected with the issue. Liquidity of Cash and Short-Term Investments According to Kaplan and Zingales (1997: 169), liquidity of cash is the ability you have to turn any asset into cash fast. Saleem and Rehman (2011:95) describe liquidity as an ability to obtain or offset a security without influencing the price of the asset. Moreover, Diamond and Dybvig (1986:55) posit that liquidity of cash is significant because it assists in ensuring that a firm can access its liquid assets where and when they are required is a major task for any cash manager. In order for any firm to earn a short-term return, the firm will hold some cash assets in the form of short-term investments. Given that such shorter-term investments are a substitute for money, offering liquidity and preserving the principle should be the major concern. Gaining a competitive return for a business should be considered as the business holds onto liquid cash. Whereas it is okay for businesses to have several illiquid assets, it is important that some of the wealth of the businessbe easily soldif required.Gill and Shah (2012:70) assert that these of illiquid assets have the prospective for long-term benefits, but the business has to be in a situation such that it may not need to sell them. The business needs to be able to hold onto the assets until the right moment when they appreciateor when it is ready to offset them to a potential buyer. Diamond and Dybvig (1986:37) stress that that some short-term investments could be developed for making planned payments, such as those intended to be held for a particular period and for a specific use. Some firms hold short-term investments even though they have not scheduled a specific use for them. This has also been witnesses where the rates of returns on short-term investments of the businesses are very slim. For instance, some firms compete in industries that have opportunities for growth, which arise unexpectedly (Hoshi, Kashyap & Scharfstein 1991:36). If such a firm perceives that it can exploit the opportunity, it is likely to earn more than the degree of short-term investments. Research by Opler et al. (1999:6) shows that such companies hold comparatively high degrees of marketable securities. On the other end, cash holdings are least significant to big companies with high ratings of credit, because they have inexpensive and quick access to capital markets (Martínez-Sola, García-Teruel & Martínez-Solano 2013:170). As anticipated, such companies hold comparatively low cash levels. Holding short-term investments by firms minimize the firm’s risk of experiencing a crisis in liquidity. Moreover, a stockpile in the short-term investments further minimizes transaction costs that arise from the securities issuance because the investments can be liquidated instead (Saleem & Rehman 2011:95). Porter and Kramer (2011:72) describe liquid assets as those that are easily accessible. In some cases however, even cash can be somewhat illiquid for instance, a certificate of deposit. With cash deposits, the business’s money will be held up for a set period. A business under this situation cannottherefore access its money early without incurring at most times hefty penalties. Thus, the business needs to consider how it will accessits wealth if needed. Kaplan and Zingales (1997: 170) affirm that businesses, which hold liquid assets in the form of cash, access them more easily and quickly. For example, a business having a portion of its emergency cash in a high-yield savings account, which it can access quickly, a big portion of its emergency assets could be obtainable within a few days. There are various reasons for a firm’s decision to holding cash. These reasons are the speculative and precautionary term instruments (Gill & Shah 2012:72).The speculative reason is holding into cash in order to take advantage of unanticipated opportunities. Typically, this aim is adopted only after the company attains its safety motives (Damodaran, 2012:12). Cash held for this aims could be invested in short term and longer-term instruments. The precautionary motive is for holding onto cash in case of emergencies. This cash is required to satisfy the precautionary and speculative motives in order to pay quickly. This motive exists and is fulfilled in order to maintain a pool of liquid cash, which can be rapidly accessed during an emergency. Even though cash is the liquid asset, other assets like marketable securities are close alternatives for cash. The capacity toborrow fastis also a close alternative for cash for instance, having a credit line. The transaction motive of holding cash is usually for the purposes of meeting the day to day needs of a business such as paying daily needs of a business including paying bills and wages (Damodaran, 2012:14). Given that these balances are held by a business to design near term payments, companies ensure that this motive is fulfilled by holding cash balances. If the cash inflows and outflows of the firm are matched closely, its transactional balances can be reduced. Criticism for Holding onto Liquid Cash or Short-Term Investments However, there are several criticisms of withholding liquid cash or making short-term investments by businesses. According to Gertler, Martinez, and Rubio-Codina (2012:165), one drawback of more liquid cash is limited investment returns. Holding cash generates no investment return apart from standard inflation rates over time. Savings accounts and basic checking usually have very limited interest yields. Banks provide better returns for longer access to company funds. For instance, certificates of deposit commonly generate yearly returns slightly greater than regular savings accounts. Good stock investments can generate great returns, but businesses will be required to offset the stock and wait for the trade to resolve to earn money. Several investments prevent the income of a business from taxes. For instance, a business with money invested in its business can offset its profits by accounting for capital expenses alongside other expenditures, and thus, enabling the value of its business to improve without paying a higher tax rate in order to improve its wealth. Liquid assets (cash) are more open to taxation. Gertler, Martinez and Rubio-Codina (2012:166) provide that businesses, which engage in short-term investing do not always earn profits within a short period. Most of the investments from such businesses may decline in the short term but increase steadily in the long term with rising returns. Moreover, the quantification of the growth in the short-termis troublesome. Damodaran (2012:16) explain that this is because investments in the short-term is a strategy founded on responding to changes in prices as opposed to fundamental value. Conclusion This essay has narrowed down on the most significant questions that need to be considered when investing as well as how businesses need to consider on how often they need to access their money. The study has established that liquid assets in the form of cash are readily available to a business for spending. Other assets are normally more difficult to convert into money, but may have their own its merits. Nevertheless, a business with too much liquidity can inhibit it from growing its wealth efficiently.Liquidity has been defined as the portion of the wealth of a business that is liquid, or, which is easily convertible into cash and it includes cash together with any investment that can be easily sold quickly, such as bonds and stocks. Mutual funds and savings accounts are also liquid investments because they can be convertedquicklyinto cash. Some of the liquid ways of holding onto money include money and savings market accounts, and basic checking. Holding liquid cash is advantageous because it enables the firm to have a quick access to its cash as required. Cash accounts are crucial to everyday budgeting, and they alsocome in handy whenever businesses have an unexpected expense or require money for speculative or for emergency purposes. A business that keeps its money in less liquid and low-return accounts can experience challenges in paying for their routine purchases or meeting unexpected bills including repairs or medical fees. However, there are also criticisms against holding liquid cash or making short-term investments. From this topic, I have learnt that whereas liquid assets are easy to turn into cash, they might not portray similar potential for growth as assets that are less liquid. For instance, certificates of deposit generate greater interest rates compared to savings accounts. Nevertheless, businesses deposit a bigger chunk of their money in banks for longer periods while their savings accounts provide them with immediate access to their money at any particular time. A business with too much liquidityis less likely to take advantage of higher rates of interest as well as other long-term opportunities for investment. References Damodaran, A 2012 Investment valuation: Tools and techniques for determining the value of any asset, John Wiley & Sons. Diamond, D. W & Dybvig, P 1986, “Banking theory, deposit insurance, and bank regulation,” Journal of Business, vol. 6, no. 23, pp. 55-68. Gertler, P. J, Martinez, S. W & Rubio-Codina, M 2012, “Investing cash transfers to raise long-term living standards,” American Economic Journal: Applied Economics, vol. 4, no.1, pp. 164-192. Gill, A & Shah, C 2012, “Determinants of corporate cash holdings: evidence from Canada.” International Journal of Economics and Finance, vol. 4, pp. 70-91. Hoshi, T, Kashyap, A & Scharfstein, D 1991, “Corporate structure, liquidity, and investment: Evidence from Japanese industrial groups,” The Quarterly Journal of Economics, vol. 3, pp. 33-60. Kaplan, S. N & Zingales, L 1997, “Do investment-cash flow sensitivities provide useful measures of financing constraints?”, The Quarterly Journal of Economics, vol. 3, pp. 169-215. Martínez-Sola, C, García-Teruel, P & Martínez-Solano, P (2013). “Corporate cash holding and firm value”, Applied Economics, vol. 45, no. 2, pp. 161-170. Opler, T, Pinkowitz, L, Stulz, R & Williamson, R 1999, “The determinants and implications of corporate cash holdings”, Journal of financial economics, vol. 52, no. 1, pp. 3-46. Porter, M. E & Kramer, M 2011, “Creating shared value.” Harvard business review, vol. 89, no. 1, pp. 62-77. Saleem, Q & Rehman, R 2011, “Impact of Liquidity Ratios on Profitability”, Interdisciplinary Journal of Research in Business, vol. 1, no. 7, pp. 95-98. Read More