Cash is something companies love to have but if you can believe it, there is such a thing as having too much. Many things contribute to the reasons behind a company's cash position. At first glance, it makes sense for investors to seek out companies with plenty of cash on the balance sheet. 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. There are both good and bad reasons for a company to have coffers that are overflowing.
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 do not 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 producers, 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 a 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.
More often than not, 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 the managers' pressure to perform.
How Companies Disguise the Excess
Do not 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." With this mind, be wary of balance sheet items like "strategic reserves" and "restructuring reserves," as they can be scrutinized as banal rational for stockpiling cash.
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, but usually at the cost of investor returns.
The Bottom Line
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.