Non-synchronisation of cash flows and short costs

A firm's need for cash depends on how far its receipts and payments fail to match, and on what it costs to be short of cash or to hold too much of it.

1. Non-synchronisation of cash flows. Cash is needed for day-to-day transactions (purchases, expenses, taxes, dividends) because there is no complete synchronisation between cash receipts and cash payments: at times receipts exceed payments, at times payments exceed receipts.

• The wider and more irregular the gap between inflows and outflows, the larger the cash balance the firm must hold.
• Expected payments can be estimated, so a cash budget shows when the gap will open; a shortfall may be met by a bank overdraft and a surplus put into marketable securities.
• Even well-forecast flows vary: a debtor may delay payment or a supplier may withdraw credit, so some cash is held as a precaution.

2. Short costs. These are the costs of running short of cash. Any shortage of cash hampers the firm's operations. Typical short costs are:

• transaction costs of raising cash at short notice, such as selling securities or arranging a loan;
• borrowing costs, the interest (often high) on emergency borrowing;
• lost cash discounts on purchases, when bills cannot be paid early;
• the cost of a poorer credit standing, from delayed payments to suppliers, lenders or employees.

Balancing the two. Cash itself earns nothing ("cash is the most unproductive of all the assets"), so excess cash has its own cost. The firm sets its cash balance where the short costs of holding too little balance the cost of holding too much, given how badly its cash flows are synchronised.