Precautionary Cash Holdings as An Operating Asset and Financial Statement Analysis

Abstract

Firms' cash holdings have dramatically increased over time, which is a puzzling phenomenon because surplus cash could encourage managers to make value-destroying decisions. However, cash can be value preserving if it enables firms to withstand unexpected shocks. We examine the latter explanation in this paper. We provide a method to calculate the amount of cash a firm must keep in order to achieve a desired level of continuity; that is, to keep the firm failure risk below a given threshold. We show that this insurance amount, which we argue is an operating asset, similar to keeping inventory to weather demand and supply shocks, differs based on firm operating characteristics and economic environment. Considering a portion of cash as an operating asset has implications for financial statement analysis and firm performance measurement. It changes how firm's assets, financial position, and operating performance are calculated.

Keywords: Cash holding, Precautionary motive, Working capital, Operating asset, Delisting, Idiosyncratic volatility, Financial statement analysis JEL Classifications: M21, M41, G32, G33

JEL Classification: G32, G33, M41