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 a company's cash position. At first glance, it makes sense for investors to seek out companies with low debt loads. As for cash, there are both good and bad reasons for a company to have coffers that are overflowing.
Key Takeaways
- Companies sometimes have the unfortunate problem of having too much cash.
- If cash is a permanent fixture on a balance sheet, investors will wonder why the money is not being put to work.
- Growing cash can also indicate the company is generating strong revenues.
- Capital-intensive companies have greater difficulty raising cash because of the ongoing need to replenish equipment.
- Investors can get a better sense of a company's cash needs by looking at things like future cash flows, business cycles, capital expenditure plans, and upcoming liability payments.
Good Reasons for Extra Cash
There are often good reasons to find more cash on the balance sheet than financial principles suggest is prudent. For starters, a persistent and growing reserve typically 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 as capital-intensive companies, so their cash builds up.
By contrast, companies with a lot of capital expenditures, like steel producers, must invest in equipment and inventory that must be replaced regularly. 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 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 money.
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 the price paid for having the cash as measured by the company's cost of capital.
If a company 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 to continually prune growing expenses. Large cash holdings also remove some of the pressure on management to perform.
How Companies Disguise 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 where they are tempted to pursue "empire building." With this in mind, be wary of balance sheet items like "strategic reserves" and "restructuring reserves," as they can be scrutinized as a banal rationale 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 positions 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, capital expenditure plans, and emerging liability payments, investors can calculate how much cash a company really needs.
FAQs
Liquidity overload: Why having too much cash may be bad for business. In today's uncertain marketplace, many businesses are stashing operating cash in their bank accounts, even though they might not have imminent plans to deploy their reserves. However, excessive “rainy day” funds could be an inefficient use of capital ...
What happens when a company has too much cash? ›
This situation results in a constant destruction of capital and increased risk by restricting the company's access to capital. It also lowers its market value relative to book assets and book equity while increasing its real debt burden (if the company is financed).
Is it good if a company has a lot of cash? ›
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 to continually prune growing expenses. Large cash holdings also remove some of the pressure on management to perform.
Why is it not advisable for a company to have too much cash? ›
As debtors take longer and longer to pay, the risk of default increases which means you may end up with more bad debts. Ultimately, these will come home to roost. Similarly, ample cash may mean your team are not as motivated to maintain appropriate stock levels, which could result in a blow out in inventory.
What does it mean when a company has excess cash? ›
Excess cash refers to the cash over what the company needs to meet its short-term expenses. While business owners know of the consequences of cash shortage, they often miss out on the perils of having excess cash. Too much cash negatively impacts the company's performance in both subtle and obvious ways.
Is it illegal to have too much cash? ›
Potential Confiscation of Large Amounts of Cash
Despite there being no law against possessing large sums of cash, it is inadvisable to keep excess cash assets on your person. According to the American Civil Liberties Union (ACLU), a collection of laws known as "Civil Asset Forfeiture" allow: "…
Is it possible for a company to have too large a cash balance? ›
In today's uncertain marketplace, many businesses are stashing operating cash in their bank accounts, even though they might not have imminent plans to deploy their reserves. However, excessive “rainy day” funds could be an inefficient use of capital.
Why do companies hold so much cash? ›
In short, companies hold cash because it helps them avoid premature failures that decimate shareholder value.
What is the downside of holding too much cash? ›
Lower returns: Since cash is largely a risk-free asset, investors don't get the “risk premium” that other investments, like mutual funds or GICs, may come with. Inflation risk: While cash has no capital risk, inflation can erode its purchasing power – meaning you wouldn't be able to buy as much with it in the future.
Why is it a financial risk for businesses to have too much cash on hand? ›
If a company has cash reserves while simultaneously carrying debt on its balance sheet, such as equipment loans, mortgages and credit lines, it will pay higher interest rates on loans than it's earning from the bank accounts. This spread represents the carrying cost of cash.
Excess cash calculation
If Total Current Assets are greater than (2 x Total Current Liabilities), then Excess Cash is the lower of: Cash and Short Term Investments OR. Total Current Assets - (2 * Total Current Liabilities).
How much cash should a company have? ›
When it comes to cash-flow management, one general rule of thumb suggests enough to cover three to six months' worth of operating expenses. However, true cash management success could require understanding when it might be beneficial to invest some cash elsewhere as well.
Why is it good for a company to have a large amount of cash? ›
Insufficient cash on the balance sheet prevents the company from needing to borrow money. Organizations should keep some extra cash on hand to avoid taking out short-term loans because borrowing prices are high. Excess cash on hand is a sign of the company's short-term financial health.
What is the danger of holding too much cash? ›
Having too much cash sitting on the sidelines in a money market fund might seem like a safe move. But history shows there's an opportunity cost to playing it too safe. Simply put, cash has less growth potential and most likely won't help you reach your long-term goals.
What are the disadvantages of excess cash in business? ›
Surplus cash can have three negative consequences:
It can reduce your return on assets. Surplus cash that isn't needed for business operations is unproductive. This cash could instead be invested in income-generating projects. It can elevate your cost of capital.
What does it mean when a company has a lot of cash on hand? ›
Cash on hand, sometimes referred to as cash or cash equivalents (CCE), is the total amount of cash a business can access, whether from its on-site paper bills or from its bank accounts and assets. Typically, business owners consider any asset they can liquidate into cash in 90 days or fewer as cash on hand.
What could a company do with excess cash on the balance sheet? ›
Along these lines, now may be the perfect time to maximize your capital expenditures. Spending excess cash on buildings, property, or equipment not only sets the stage for future growth, it also allows you to increase your business deductions when tax time comes.
