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strategy, the firm is a short-term lender during part of the year and a borrower during the rest.
What is the best level of long-term financing relative to the cumulative capital requirement? It is hard to say. There is no convincing theoretical analysis of this
question. We can make practical observations, however. First, most financial managers attempt to “match maturities” of assets and liabilities.1 That is, they
largely finance long-lived assets like plant and machinery with long-term borrowing and equity. Second, most firms make a permanent investment in net
BETA
working capital (current assets less current liabilities). This investment is financed from long-term sources.
Current assets can be converted into cash more easily than long-term assets. So firms with large holdings of current assets enjoy greater liquidity. Of Page 859
course, some current assets are more rapidly converted into cash than others. Inventories are converted into cash only when the goods are produced, sold,
and paid for. Receivables are more liquid; they become cash as customers pay their outstanding bills. Short-term securities can generally be sold if the firm
needs cash on short notice, and are therefore more liquid still.
Whatever the motives for maintaining liquidity, they seem more powerful today than they used to be. You can see from Figure 30.2 that, particularly in the
easy-money years before the financial crisis, firms in the United States increased their holdings of cash and marketable securities.
FIGURE 30.2 Median ratio of cash to assets for U.S. nonfinancial firms, 1980–2020.
Source: Compustat.
Some firms choose to hold more liquidity than others. For example, many high-tech companies, such as AbbVie and Gilead Sciences, hold huge amounts of
short-term securities. On the other hand, firms in old-line manufacturing industries—such as chemicals, paper, or steel—manage with a far smaller reserve of
liquidity. Why is this? One reason is that companies with rapidly growing profits may generate cash faster than they can redeploy it in new positive-NPV
investments. This produces a surplus of cash that can be invested in short-term securities. Of course, companies faced with a growing mountain of cash may
eventually respond by adjusting their payout policies. In Chapter 15, we saw how Apple sought to reduce its cash mountain by paying a special dividend
and repurchasing its stock.
There are some advantages to holding a large reservoir of cash, particularly for smaller firms that face relatively high costs of raising funds on short notice.
For example, biotech firms require large amounts of cash to develop new drugs. Therefore, these firms generally have substantial cash holdings to fund their
R&D programs. These precautionary reasons for holding liquid assets are particularly important for small companies in relatively high-risk industries, and it
is these companies that are most likely to hold large cash surpluses.2
Financial managers of firms with a surplus of long-term financing and with cash in the bank don’t have to worry about finding the money to pay next month’s
bills. The cash can also help to protect the firm against a rainy day. However, there are also drawbacks to surplus cash. Holdings of marketable securities are
at best a zero-NPV investment for a taxpaying firm.3 Also, managers of firms with large cash surpluses may be tempted to run a less tight ship and may allow
the cash to seep away in a succession of operating losses. For example, at the end of 2007, General Motors held $27 billion in cash and short-term
investments. But shareholders valued GM stock at less than $14 billion. It seemed that shareholders realized (correctly) that the cash would be used to
support ongoing losses and to service GM’s huge debts.
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One study found that on average shareholders appear to value a dollar of cash at about $1.20.4 They seem to place a particularly high value on
liquidity in the case of firms with plenty of growth opportunities, but when a firm is likely to face financial distress, a dollar of cash within the firm is
generally worth less than a dollar to the shareholders.5
