Managing Optimum Cash Balances Mark Swallow mswallow@arlingclose.com

Last week my colleague Amar Jandoo (https://www.arlingclose.com/insights/are-you-holding-too-much-cash) raised the issue of cash holdings which is often referred to as liquidity.

Liquidity is a key requirement of an effective treasury operation but is holding excessive liquidity an expensive luxury in the current interest rate environment?

One of the main objectives of treasury management is knowing what your optimum cash balance should be. Cash is traditionally considered to be the physical currency that we used to carry around in our wallets but for the purposes of treasury management it has a broader definition covering near cash assets which are the liquidity instruments used on a daily basis by our client base. For example, call accounts, MMF’s etc are effectively cash and are therefore referred to as cash.

So why do organisations hold cash? In his publication on The General Theory of Employment, Interest, & Money, Keynes outlined three reasons, or motives, for holding money or cash:

  • Transaction Motive: to pay for goods or services as It is needed for conducting everyday transactions or purchases.
  • Precautionary Motive: Cash is a relatively safe investment. Cash investments rarely lose value and are therefore held for safety reasons in a balanced portfolio.
  • Asset or Speculative Motive: It can provide a return to the holders of cash assets.

As negative returns eat into the value of cash holdings the main reason for local authority cash balances should be at levels that meet the transaction motive only, however we are all prudent in nature and a degree of cash will always held on a precautionary basis but are you holding too much to cover unknown events?

To manage the cash resources of an organisation as effectively and efficiently as possible an optimum cash balance should be established where enough cash is held to meet the true liquidity needs of the organisation.

To get to a point where the amount of cash held is at the right level you need to understand all sources of income and items of expenditure within your organisation. Can you answer this question honestly “Do you know as the treasury manager know how much cash you need, how much you have, where the cash is, what the sources of cash are, and where the cash will be used?” If not, then you will find it difficult to understand what your optimum cash holding strategy should be.

There are many parts of a local authority’s cash flows which can be forecast with a degree of certainty. The monthly payroll should be stable, precept payments to other precepting authorities are set in advance of the financial year, monthly local taxation receipts will be easy to predict as will grant income. There will be payments and receipts that are more cyclical in nature and will require a review of historic trends to try to forecast and then there will be items that are difficult to forecast and this is often the reason for excess liquidity as that precautionary motive kicks in.

So, are there ways in which the optimum cash balance can be calculated?

Several theoretical models exist. The Baumol model aims to determine the optimum amount of cash that is held under conditions of certainty. The objective of this model is to minimise the sum of the costs of transactions (selling investments or borrowing money short-term) and the opportunity cost of holding cash balances.

An alternative model is the Miller-Orr model which aims to calculate an upper and lower limit for cash balances. When the upper limit is reached, a transfer of cash to marketable instruments is made. When the lower limit is reached, a transfer from those instruments into cash occurs. The purpose of this model is to satisfy cash requirements at the least cost and a major assumption is the randomness of cash flows.

These models are probably too theoretical and not suitable for local authority treasury management purposes but some analysis should be undertaken to establish how much liquidity is required and how much of a local authorities cash resources can be exposed to longer term investments and ultimately what the cost is of having excessive liquidity.

At Arlingclose we have developed our liability benchmark model to assist clients in making decisions based on long term cash forecasts and can work with you to expand this to come to a more detailed understanding of your optimum in-year cash requirement. If you think we can help then please get in touch to discuss in more detail.