Why cash isn’t always king


I like cash and I like companies that have cash. But what if they have too much? In other words: a lazy balance sheet. Now first, let me explain why too much cash is lazy. 

Return on equity (RoE) is a popular metric for measuring a company’s, as well as its executives’, performance.

More cash means more assets, and therefore increases the equity part of the equation. With higher equity, the return will decrease if all else remains the same.

More cash will also boost the net asset value (NAV). 

Now certainly we could argue that shareholders can – and should – look through this issue and discard some or even all of the cash when determining various fundamental ratios. 

But the point is that cash is inherently lazy as it generates a modest rate of interest at best. We may want a company to grow profits and dividends by double digits, but cash is likely to be earning well below that level – hence me calling it lazy.

What should companies do with extra cash?

The next question would be what companies should do with the extra cash. And companies do have a number of options. 

They can use it to pay off debt – especially if the cost of the debt is more than the interest being earned. 

However, a well-functioning company should have some debt as it essentially gears its balance sheet and grows profits as it repays the money.

Another alternative is to return it to shareholders via a special dividend or via share buy-backs. 

Both these options have their issues: dividends attract a 20% dividend withholding tax (DWT); with share buy-backs, on the other hand, companies have to be certain that they’re being done at decent valuations. 

In my view, independent advice should be sought on the valuation, because buying one’s own overpriced shares is not a great investment.

The last option is to spend the cash pile. But here’s the risk: the company might be so eager to spend the money that it buys almost anything – assets, which could prove to be duds later. Again – a waste of cash.

So, there is no easy answer. But a board should tackle the issue and inform investors of its plans. 

Apple currently sits on some $267bn of cash and is intending to use $100bn for increased dividends and share buy-backs. 

However, in the US dividends are taxed at 30% – a serious hit to those receiving the dividend. 

With Apple’s price-to-earnings ratio (P/E) at around 16%, it is a fair value for the stock, so share buy-backs are an option. 

But, again, I would rather they were done at a discount than just fair value.

Maybe the answer is that companies should be wary of building too large a cash pile in the first place. 

Medium-term projections should indicate the potential growth of cash, and a higher dividend payout sooner rather than later could work –  albeit with the dividend being taxed. 

Smaller strategic bolt-on acquisitions would perhaps also be a good option, rather than large acquisitions that often end up being a very poor deal. 

Small and smart deals along the way could make a real difference without the risk associated with large deals.

It’s important to have a plan

The irony of course is that the main aim of a company is to generate cash for shareholders, but then it needs to have a plan for what to do with the cash rather than just hoarding it. 

Personally, I’ll accept share buy-backs at discount levels or small acquisitions. Or just give me the cash as dividends and I’ll take the tax hit. 

It is a tricky situation, but whatever solution it chooses, a company’s board should keep shareholders informed.

This article originally appeared in the 24 May edition of finweek. Buy and download the magazine here, or sign up for our weekly newsletter here.

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