What Determines the Composition of a Firm's Total Cash Reserves?

Abstract

Although financial managers spend significant time and effort deciding in which financial assets corporate cash reserves should be invested, we know surprisingly little about the determinants of the variation in the composition of the financial assets that constitute these reserves. We find that firms invest more of their cash reserves in longer-maturity, less liquid securities that earn a higher yield if they can better forecast their short-term liquidity needs. Also, financially constrained firms, which typically hold large cash reserves to meet longer-term financing needs, invest more of their cash reserves into such securities. During years when significant amounts of their cash reserves are needed to fund operations or new investment, financially constrained firms shift funds to shorter-maturity, more liquid securities that earn a lower yield. We use several different identification strategies to establish causality of our results. Our findings provide insights on an important component of corporate liquidity management practices.