Reading: Extensions and FAQ

When discussing the various items on a firm's balance sheet, we have argued that it often makes sense to distinguish between Operating cash (the amount of cash the firm needs to secure smooth business operations) and Excess cash (extra cash the firm holds, mostly because past profits were not distributed to the shareholders).

The key question is: How much cash does a firm actually need to secure smooth business operations?

There is no general answer to this question, but there are some helpful guidelines.

• Ultimately, the role of operating cash is to guarantee solvency for the firm's short-term obligations (e.g., accounts payable, short-term debt, etc.).  Therefore, firms with more such obligations will prefer to hold larger cash balances than firms with fewer short-term obligations.  
• Another important factor is the availability and liquidity of other current assets. For example, a firm with a large stock of receivables from customers with excellent credit quality and short payment terms will need comparatively less operating cash, simply because these receivables will translate quickly into cash. In contrast, a firm that grants long payment terms to customers with questionable credit quality may want to hold comparatively more cash, as it is less clear when the customers will pay their bills.
• A firm that grows rapidly will want to hold more cash than a firm that operates in a stable environment.
• Etc.

To distinguish between operating and excess cash, we often make a simplyfing assumption. A reasonable way could be to say that the cash balance should allow the firm to cover its operating expenses (for cash) for the next 2 months. Hence, we would set operating cash to 1/6 of the operating expenses.