What Is a Target Cash Balance?
A target cash balance describes the ideal level of cash that a company seeks to hold in reserve at any given point in time. This figure is optimized to strike a balance between the opportunity costs of holding too much cash and the balance sheet costs of holding too little.
Companies with excess cash on hand may be missing out on investment opportunities and experience cash drag, while companies that are cash poor can often be forced to make otherwise undesirable transactions to free up more operating capital and may not have cash on hand should a good opportunity arise.
- A target cash balance is the optimal level of cash that a firm or investor should have on hand or in their portfolio.
- Too much cash can be a drag on overall investment performance and cash not invested may be subject to opportunity costs.
- Too little cash means that certain opportunities cannot be seized when they arise and can lead to undesirable liquidity problems causing the forced sales of assets.
How Target Cash Balances Work
It is wise for individual investors to set their own target cash balance as well. Through portfolio management and clearly defined financial goals, investors can at least approximate what percentage of their holdings should be in cash to avoid the pitfalls listed above.
Under most scenarios, excess cash balances offer a buffer of liquidity for unexpected events, both good and bad. A "rainy day" fund can help offset the financial distress brought on by unplanned cash flow disruptions. While a cash reserve can also help seize timely investment opportunities that surface unexpectedly, such as a competitor suddenly closing their doors and selling their assets below market value.
The target cash balance is often part of a larger investment or business strategy. Various industries will maintain different target cash balances depending on where the economy is at on different points in the market cycle. For instance, when technology is hot, larger tech players will maintain a healthy cash reserve for acquisitions. In contrast, retailers may be experiencing a lean period and will operate with target cash balance below normal levels.
Target cash balances will fluctuate based on economic conditions and opportunities, factors unique to the industry or company, and the availability of funding options. During an easy money monetary environment, maintaining elevated levels of target cash balances is less costly.
Pros & Cons of Cash Balances
A cash position represents the amount of cash that a company, investment fund, or bank has on its books at a specific point in time. The cash position can be a sign of financial strength and liquidity. In addition to cash itself, this position often takes into consideration highly liquid assets, such as certificates of deposit, short-term government debt, and other cash equivalents. However, too large of a cash position can often signal waste, as the funds are generating very little return.
"Cash drag" is a common source of performance drag in a portfolio. It refers to holding a portion of a portfolio in cash rather than investing this portion in the market. Because cash typically has very low or even negative real returns after considering the effects of inflation, most portfolios would earn a better return by investing all cash in the market. However, some investors decide to hold cash to pay for account fees and commissions, as an emergency fund or as a diversifier of other portfolio investments.