Cash is something companies love to have. But can they have too much of the stuff?

Provided things are going well, debt financing helps a company gear up to boost returns, but investors know the dangers of debt. When things don't go as planned, debt can spell trouble.

But what about a company's cash position? If excess debt is a bad thing, does it follow that a lot of cash is a good thing? At first glance, it makes sense for investors to seek out companies with plenty of cash on the balance sheet. After all, cash offers protection against tough times, and it also gives companies more options for future growth.

Tutorial: Introduction To Fundamental Analysis

The Theories
Unfortunately, nothing is quite that simple. For investors digging into company fundamentals, a big pile of cash can signal many things - good and bad. How investors interpret cash reserves depends on how the cash got there, the kind of business the company is and what managers plan to do with the cash.

Corporate finance textbooks say that each firm has its own appropriate cash level, and companies ought to keep just enough cash to cover their interest, expenses and capital expenditures; plus they should hold a little bit more in case of emergencies. The current ratio and the quick ratio help investors determine whether companies have enough coverage to meet near-term cash requirements.

Theory also holds that any extra cash over and above those levels should be redistributed to shareholders either through dividends or share buybacks. If the company then discovers a new investment opportunity, managers should turn to the capital markets to raise the needed funds.

Good Reasons for Extra Cash
That said, there are often good reasons to find more cash on the balance sheet than financial principles suggest prudent. To start, a persistent and growing reserve often times signals strong company performance. Indeed, it shows that cash is accumulating so quickly that management doesn't have time to figure out how to make use of it.

Highly successful firms in sectors like software and services, entertainment and media don't have the same levels of spending required by capital-intensive companies. So their cash builds up.

By contrast, companies with a lot of capital expenditure, like steel makers, must invest in equipment and inventory that must be regularly replaced. Capital-intensive firms have a much harder time maintaining cash reserves. Investors should recognize, moreover, that companies in cyclical industries, like manufacturing, have to keep cash reserves to ride out cyclical downturns. These companies need to stockpile cash well in excess of what they need in the short term.

Bad Reasons for Extra Cash
All the same, textbook guidelines should not be ignored. High levels of cash on the balance sheet can frequently signal danger ahead. If cash is more or less a permanent feature of the company's balance sheet, investors need to ask why the money is not being put to use. Cash could be there because management has run out of investment opportunities or is too short sighted and doesn't know what to do with the cash.

Sitting on cash can be an expensive luxury because it has an opportunity cost, which amounts to the difference between the interest earned on holding cash and price paid for having the cash as measured by the company's cost of capital. If a company, say, can get 20% return on equity investing in a new project or by expanding the business, 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 should be returned to shareholders.

Don't be fooled by the popular explanation that extra cash gives managers more flexibility and speed to make acquisitions when they see fit. Companies that hold excess cash carry agency costs whereby they are tempted to pursue "empire building". Top managers can fritter away cash on wasteful acquisitions and bad projects in a bid to boost their personal power and prestige. With this mind, be wary of balance sheet items like "strategic reserves" and "restructuring reserves". They are often just excuses for hoarding cash.

Even worse, a cash-rich company runs the risk of being careless. The company may fall prey to sloppy habits, including inadequate control of spending and an unwillingness continually to prune growing expenses. Large cash holdings also remove some of managers' pressure to perform.

There is much to be said for companies that raise investment funds in the capital markets. Capital markets bring greater discipline and transparency to investment decisions and so reduce agency costs. Cash piles let companies skirt the open process and avoid the scrutiny that goes with it.

To play it safe, investors should look at cash position through the sieve of financial theory and work out an appropriate cash level. By taking into account the firm's future cash flows, business cycles, its capital expenditure plans, emerging liability payments and other cash needs, investors can calculate how much cash a company really needs.

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