Cash Reserves: What They Are and How They Work

What Are Cash Reserves?

Cash reserves refer to the money a company or individual keeps on hand to meet short-term and emergency funding needs. Short-term investments that enable customers to quickly gain access to their money, often in exchange for a lower rate of return, can also be called cash reserves. Examples include money market funds and Treasury Bills (T-Bills).

How Cash Reserves Work

Having significant cash reserves gives an individual, group of individuals, or company the ability to make a large purchase immediately. It should also ensure they are able to cover themselves when they go through a rough patch financially and need to make sudden, unexpected payments.

Companies

Firms hold cash reserves to meet all expected and unexpected costs in the short run, as well as to finance potential investments. Cash is the most liquid form of wealth, but short-term assets, such as three-month Treasury Bills (T-Bills), are also considered cash reserves because of their high liquidity and short maturity dates.

Some companies, including Alphabet Inc. (GOOGL), Apple Inc. (AAPL), and Microsoft Corp. (MSFT), currently have billions in cash reserves. Needs vary, but, in general, experts recommend that businesses have three to six months of operating expenses tied up in cash or highly liquid assets.

Banks

Banks are subject to requirements on the amount of cash reserves they must hold, as mandated by the U.S. Federal Reserve (Fed). This amount is determined as a percentage of deposit liabilities, called the net transaction accounts, which is, in effect, the money that people and companies put into banks that needs to be paid back at some point in the future.

These reserves must be held in the form of either vault cash or deposits in a Federal Reserve Bank. Since December 27, 1990, non-personal time deposits and eurocurrency liabilities are not subject to any cash reserve requirement.

Individuals

Individuals are advised to have enough cash in reserve to last at least three to six months in case of an emergency. They hold their cash reserves in bank accounts or in short-term stable investments that are not likely to lose value. That way, they can withdraw these emergency funds or sell these investments at any time without losing money, regardless of how well the stock market is performing.

An individual's cash reserves might consist of money in a checking account, savings account, money market fund, or money market account, as well as short-term Treasury Bills (T-Bills) and certificates of deposit (CDs). Individuals and businesses that lack sufficient cash reserves can resort to credit or, in extreme cases, may be forced into bankruptcy.

Disadvantages of Cash Reserves

Sitting on plenty of cash sounds great, right? Not always. Having cash reserves can come in handy when there are cash flow problems and money is required for something immediately. However, it is important to strike the right balance as too much can be detrimental.

Hoarding excess cash can lead to missed opportunities. Higher returns could have been generated by reinvesting some of that extra cash back into the business. In theory, the amount of money those investments generate in revenue should easily surpass the rates that a checking account pays.

For individuals, keeping too much money in cash reserves can also be detrimental. Yes, they are safer. But they also generate much lower returns than, say, investing in stock, bond, REIT, gold, alternative assets, or any asset class diversified portfolios. Over the years, this difference becomes very noticeable due to inflation and the power of time value of money compounding.