Money is something that companies love to have, but if you can believe it, there is excess money. Many things contribute to a company’s cash position. At first glance, it makes sense for investors to look for companies with a lot of cash on the balance sheet. As long as things go well, debt financing helps a company prepare to increase its profits, but investors know the dangers of debt. When things don’t go as planned, debt can spell trouble. When it comes to cash, there are good and bad reasons for a company to have coffers that overflow.
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Good reasons to have extra money
There are often good reasons for finding more money on the balance sheet than financial principles suggest is prudent. For starters, a persistent and growing reserve often indicates strong company performance. In fact, it shows that cash accumulates so quickly that management has no time to figure out how to use it.
Key concepts
- Businesses sometimes have the unfortunate problem of having too much cash.
- If cash is a permanent item on the balance sheet, investors will wonder why money isn’t put to work.
- Cash growth may also indicate that the company is generating strong revenue.
- Capital-intensive companies have a harder time obtaining cash due to the constant need to replenish equipment.
- Investors can get a better idea of a company’s cash needs by looking at things like future cash flows, business cycles, capital expenditure plans, and upcoming liability payments.
Highly successful companies in industries such as software and services, entertainment, and the media do not have the same levels of spending required as capital-intensive companies. So your money accumulates.
By contrast, capital-intensive companies, such as steel producers, must invest in equipment and inventory that must be replaced regularly. Capital-intensive companies find it much more difficult to maintain cash reserves. Investors should also recognize that companies in cyclical industries, such as manufacturing, have to maintain cash reserves to cope with cyclical declines. These companies need to accumulate cash well above what they need in the short term.
Bad reasons to have extra cash
Regardless, textbook guidelines should not be ignored. High levels of cash on the balance sheet can be a sign of danger. If cash is more or less a permanent feature of the company’s balance sheet, investors must wonder why the money is not being used. The cash could be there because management has run out of investment opportunities or is too shortsighted and doesn’t know what to do with the money.
Sitting on cash can be an expensive luxury because it has an opportunity cost, which equates to the difference between the interest earned for holding the cash and the price paid for holding the cash measured by the cost of capital of the business.
If a company can get a 20% return on capital invested in a new project or business expansion, it is a costly mistake to keep the cash in the bank. If the project’s return is less than the company’s cost of capital, the cash must be returned to the shareholders.
In most cases, a cash-rich business runs the risk of being sloppy. The company can fall prey to sloppy habits, including inadequate control of expenses and an unwillingness to continually reduce rising expenses. Large amounts of cash also take some of the pressure off management to perform.
How companies disguise excess
Don’t be fooled by the popular explanation that the extra money gives managers more flexibility and speed to make acquisitions when they see fit. Companies with excess cash carry agency costs where they are tempted to pursue “empire building.” With this in mind, be wary of balance sheet items such as “strategic reserves” and “restructuring reserves”, as they can be viewed as a banal justification for accumulating cash.
There is a lot to be said for companies that raise investment funds in the capital markets. Capital markets bring greater discipline and transparency to investment decisions, thus reducing agency costs. Cash piles allow companies to circumvent the open process and avoid the scrutiny that comes with it, but usually at the expense of investor profits.
Final conclusion
To play it safe, investors must look at cash positions through the sieve of financial theory and work out an appropriate cash level. Taking into account the company’s future cash flows, business cycles, capital expenditure plans, and emerging liability payments, investors can calculate how much cash a business actually needs.
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