Reasons for Extra Cash
High revenues and significant performance growth increase a company’s cash reserve and may indicate that cash accumulation is so quick that management does not have ample time to put it to best use.
Different industries and companies within the same industry have varied cash requirements. So, there is no one-size-fits-all formula to maintain adequate cash. Successful software, services, entertainment, and media companies do not have high spending, resulting in cash accumulation. On the other hand, companies in capital-intensive industries (metals, automobiles, mining, oil and gas, manufacturing, etc.) have high expenses and need to maintain and replace inventory and equipment. They find it tough to build cash reserves despite high revenue. Companies in cyclical industries (airlines and luxury goods manufacturing) have different cash requirements during different periods of the year to ride out cyclical downturns. So, their need to maintain cash reserves varies throughout the year.
How Does Excess Cash Impact Your Company’s Growth?
A company’s balance sheet showing ongoing high cash levels for a long time indicates financial irregularity. It also shows that management is not efficiently managing cash, that they have run out of investment opportunities, and do not know what to do with the excess cash.
Holding on to excess cash is an expensive luxury that can cost the company dearly. The company incurs an opportunity cost, which is the foregone funds the business could have earned by choosing an investment option. Effective decision-making helps capture opportunity costs. Excess cash also puts the management team under scrutiny.
Excess cash has three negative impacts:
- It lowers your return on assets
- It increases your cost of capital
- It increases business risk and destroys value while making the management overconfident.
Lowered Return on Assets
Excess cash not required for the company’s operations does not help. This cash could be invested in projects to generate income. Business owners miss out on opportunities to generate additional income by holding on to excess cash, resulting in a lower return on assets (ROA) for their company.
For example, a business has total assets of $2,000,000. The total assets include cash of $300,000 or 15 percent. Annual net income after tax is $200,000, which calculates to 10 percent return on assets ($200,000/$2,000,000).
We can determine the effect of cash on the total return on assets if we know that the cash portion of assets earns only 2 percent annual interest. Let us assume that all the cash in the company is in excess for illustration purposes. So, when we compare a 2 percent return on cash and a 10 percent total return on assets, we can say that the total return on assets will increase if we remove cash.
When we remove cash from total assets, they amount to $1,700,000 ($2,000,000 less $300,000). Remove the interest income on cash also, which amounts to $6,000 (2% of $300,000).
The annual net income after tax now calculates to $194,000 ($200,000-$6000). The ROA is 11.5 percent ($194,000/$1,700,000). We received a 1.5 percent higher ROA by removing excess cash, making it a 15 percent overall increase.
Increased Cost of Capital
Too much cash on hand increases the cost of capital (COC), which is the cost a company bears to purchase its assets by either borrowing or using cash. While the cost of borrowed money is the interest payment, the cost of cash is not clear. However, the company must have a return on assets over the cost of capital; otherwise, it is in trouble. Also, the COC is the minimum rate of return that the company must generate to pay debts before it generates value for shareholders.
Let us continue with the above example, as this second effect of excess cash occurs simultaneously. Suppose the COC for this company is 15 percent. With a ROA of 10 percent, the company loses money on invested capital. This is akin to selling the company’s product at a discount that amounts to less than what the company paid to manufacture it.
By lowering the equity-financed portion of cash, we can lower the most expensive portion of the COC. So, in our example, the cost of capital is reduced to about 13 percent, closing the gap between the ROA and COC.
If the cost of capital continuously exceeds the return on assets, the company slowly marches toward bankruptcy. It results in consistent destruction of capital and business risk increases, resulting in lower business value over the book assets and equity. The company also comes under an increased debt burden if it has procured the cash through borrowing.
Overconfident Management
Excess cash makes the management team overconfident. Management feels infallible, thinking nothing could go wrong with so much cash. While excess cash represents your company’s past success, it does not show its future capabilities to succeed.
The management team uses excess cash to fix mistakes instead of finding solutions to business problems. The excess cash helps management bury their mistakes so that an in-depth assessment cannot unearth the problem or failure. They may fix issues by paying legal fees, human resources, maintenance, etc. Management may even avoid traditional due diligence to hide these expenses.
Rather than adopting a growth mindset, management goes into a reactive decision-making mode. Usually, companies with excess cash overpay for acquisitions while investing cash and destroy the company’s market value.
Excess cash also leads to internal conflicts with multiple leaders having vested interests in strategic decisions, resulting in disagreements over decisions to hold cash, reinvest it, or distribute earnings to the investors. Excess cash could also result in frustrated investors due to delays in returns on their investments.
Put Your Excess Cash to Good Use
Start by paying off your debts. It makes no sense to pay more interest than necessary on debt, especially when your return on assets (ROA) is lower than the interest you pay. Management misses growth opportunities when it holds on to too much cash instead of investing in research and development. Even though such decisions go unnoticed initially, they have adverse effects on the company’s market value.
