Although every company wants to have a strong cash reserve, there are chances having too much cash can be harmful. Read on to find out how! #ThinkWithNiche
Companies fancy cash, but there is such a thing as having too much of it if you can believe it. A company's cash position is influenced by a variety of factors. At first appearance, it appears that investors should seek corporations with a large cash balance sheet. Debt financing helps a company gear up to improve returns if things are going well, but investors are aware of the risks of debt. Debt can be a problem when things don't go as planned. When it comes to money, there are both good and bad reasons for a company's coffers to be overflowing.
A Good Reason for Extra Cash
There are plenty of legitimate reasons to keep more cash on the balance sheet than economics principles would imply. For openers, a constant and growing reserve usually indicates good business performance. Furthermore, it indicates that cash is collecting at such a rapid rate that managers do not have time to figure out where to put it into active use. Successful companies in fields such as software and services, entertainment, and media do not need to invest as much as capital-intensive companies. As a result, their funds increase. Companies with high capital expenditures, such as steelmakers, must, on the other hand, invest in equipment and inventories that must be replaced regularly. Cash reserves are substantially more difficult to manage for capital-intensive businesses. Furthermore, investors should be aware that companies in cyclical industries, such as manufacturing, must maintain cash reserves to weather cyclical downturns. These businesses must keep far more cash on hand than they require in the short term.
Bad Reason for Extra Cash
Nonetheless, textbook recommendations should not be disregarded. High cash balances on the balance sheet can indicate impending danger. If cash is a near-permanent component of a company's balance sheet, investors might wonder why it isn't being put to better use. The cash may be there because management has run out of investment options or is too short-sighted to know what to do with it. Sitting on cash can be a costly luxury due to the opportunity cost, which is the difference between the interest received on cash and the price paid for having the cash, as measured by the company's cost of capital. Keeping cash in the bank is an expensive error if a firm can earn a 20% return on equity by investing in a new project or growing its operation. If the project's return falls short of the company's cost of capital, the money should be returned to the shareholders.
How Companies Disguise Excess
Don't be deceived by the widespread argument that having more cash offers managers more flexibility and speed to make purchases when they see fit. Companies with a lot of cash are tempted to pursue "empire building," therefore they incur agency charges. With this in mind, balance sheet items such as "strategic reserves" and "restructuring reserves" should be avoided, as they could be interpreted as a cynical justification for cash hoarding. Companies that raise investment funds in the financial markets have a lot to offer. Capital markets minimize agency costs by bringing greater discipline and transparency to investment decisions. Cash piles allow businesses to dodge the open process and the scrutiny that comes with it, but at the expense of investor returns.
To be safe, investors must run their buying capacity through the money payment sieve and identify an adequate cash level. Investors can evaluate how much cash a company needs by considering future cash flows, economic cycles, capital cost plans, and upcoming debt payments.