Cash should not be hold more or less than requirement and it must be just adequate. The holding of cash in adequate amount offers the following advantages:
1. Advantage Of Cash Discount
Most business purchases are made in credit basis. The duration of credit period generally ranges from 15 days to 90 days. Suppliers of trade credit must be paid within the due date. But sometimes the suppliers may offer cash discount for the early payment. Therefore, adequate cash balance needs to be held to take the benefit of cash discount offered by suppliers. Whether to take or forgo the cash discount depends on the comparative cost benefit analysis of cash discount foregone. Generally, forgoing the cash discount involves higher opportunity cost than the cost of short-term bank loan.
To be more clear, let us suppose a firm makes credit purchase under the credit term 3/10, net 40. This states that the payment of credit purchase must be made within 40 days. If the payment is made within 10 days, the firm gets 3% cash discount. With this discount offer, if the firm fails to pay within 10 days discount period, it will be paying extra 3% for using the funds for an additional 30 days. The annual cost of fund used for additional 30 days is calculated as:
Percentage cost = (Discount %/100 - Discount %) X 360/Final due date - Discount period
= (3/100-3) X 360/40-10 = 0.3763 = 37.63%
Thus annual cost of cash discount foregone is 37.63 percent, which is much higher than the cost of short-term borrowing. Hence paying the trade credit within the discount period, the firm could take the benefit of cash discount offer. For this reason, the holding of adequate cash is beneficial as it enables the firm to take this benefit.
2. Favorable Credit Rating
Holding adequate cash also enables a firm to maintain favorable credit rating. Short-term credit standing of a firm is determined mostly on the basis of current and quick ratio position. Suppliers of short-term funds evaluate the firm's short-term solvency position in terms of its ability to meet the standard line of business. Holding of adequate cash maintains the current and quick ratio at favorable position so that the firm will be able to meet the standard of credit analysis of the supplier of short-term funds.
Besides, these benefits, holding of adequate cash helps the firms to take the advantage of reduced price offer at immediate cash payment, and also maintain precaution against some emergencies such as strikes and lock-up, flood, fire, malpractices of competitors etc.
