Optimal Cash Balance
Optimal cash balance is a model that attempts to establish the magical cash balance, with the aim of minimizing the costs, while maintaining enough business liquidity. This is done, so as to ensure that business bills are paid in a timely manner, and some cash is left, for the purpose of addressing emergencies. The optimal cash balance is established through a number of steps, including managing the balance of cash, as a way of evaluating liquidity. This is done through different ways including, current ratio calculation: this method involves dividing the total current assets amount by the total current liabilities amount held.
.[1] It is also done through computing the cash to total assets fraction; computing the net liquid balance, which is computed by adding the cash available to the marketable securities – then deducting short-term notes to be paid, then the figure is divided by the total assets held. The last method is the quick ratio method, which computes the figure by deducting inventory from current assets, then dividing the figure by the total amount of assets held. From the different models of liquidity computation, the higher the number – the bigger the liquidity of the business.[2]
Optimal cash balance exists, as it is developed as a computation of the variables used in determining the liquidity and the profitability of a business. For instance, following the current ratio method in computing it, one enumerates the total current assets and the total current liabilities of the business, and then the current assets amount is divided by the current liabilities amount. Current assets and current liabilities are real phenomena in any business, including the following: cash, short-term investments, cash equivalents, inventory, and prepaid liabilities. Current liabilities include service charges, accounts payable for goods and debts of supplies that are payable within a short period.[3]
Taking the examples of the current assets and liabilities enumerated above, the particular business would calculate its liquidity as follows:
CA/ CL = X supposing that X is 5, then the liquidity level of the business is 5. In the case that the same business calculated the CA/CL and it amounted to more than 5, and then the optimal cash balance of the business will be higher, as it increases with increase in business liquidity.[4]
The motives of companies, when holding cash include that they hold cash, so as to ensure safety, especially when bond prices and stock markets are undergoing instability or turmoil. Holding cash allows companies to invest their revenues in investment stocks, growth investments and bonds, as the cash will take care of the current needs of the company. Also, the company will not need to sell their stocks, in the case that the market goes down for some time. Companies benefit from holding cash, as they are able to grasp investment opportunities that present unexpectedly. For example, investing in stock markets is high, when they want to invest in properties – where profits are anticipated in the short term. The cash held by the company is also held as an emergency fund, which can help the business, in the case business is not good, or in the case of market turmoil.[5]
The models of providing balances include current ratio calculation, computing cash to total assets fraction, computing the net liquid balance, and the quick ratio method. The models are well accepted, as they rely on real business variables like current assets and current liabilities to compute the figure. The models hold the assumptions that a business will always have in its possession, inventory, cash, current assets, and current liabilities. There is also the assumption that the securities held by the company are marketable.[6] The assumptions are relatively realistic, as any operational business will hold inventory, some cash, current debts and current payables
. However, it is not in every case that the securities held by the company will be marketable. The optimal cash balance will help in working capital management, as it gives indicators on the balance between inventory, current assets and current liabilities – which gives indicators of the need to reduce inventory, to increase current assets, or the need to cut on current liabilities. From a personal point of view, optimal cash balance computation is a tool that should be used continually, as it helps establish the liquidity of a business, as well as the capital management competency of the administration.
Works Cited
Anthony, Robert, and Breitner, Leslie. Essentials of Accounting & Post-test Booklet 8, 8th ed. New Jersey: Prentice Hall, 2003.
Rice, Anthony. Accounts Demystified: How to Understand Financial Accounting & Analysis, 4th ed. New Jersey: FT Prentice Hall, 2002.
[1], Robert, Anthony and Breitner, Leslie, Essentials of Accounting & Post-test Booklet 8, 8th ed. (New Jersey: Prentice Hall, 2003) 37.
[2] Rice, Anthony, Accounts Demystified: How to Understand Financial Accounting & Analysis, 4th ed. (New Jersey: FT Prentice Hall, 2002) 54-55.
[3], Robert, Anthony and Breitner, Leslie, Essentials of Accounting & Post-test Booklet 8, 8th ed. (New Jersey: Prentice Hall, 2003) 42.
[4] Rice, Anthony, Accounts Demystified: How to Understand Financial Accounting & Analysis, 4th ed. (New Jersey: FT Prentice Hall, 2002) 55
[5] Robert, Anthony and Breitner, Leslie, Essentials of Accounting & Post-test Booklet 8, 8th ed. (New Jersey: Prentice Hall, 2003) 93.
[6] Rice, Anthony, Accounts Demystified: How to Understand Financial Accounting & Analysis, 4th ed. (New Jersey: FT Prentice Hall, 2002) 87