Why companies hoard cash

In the aftermath of the financial crisis, firms began depleting cash reserves to survive.

But since then, S&P 500 company earnings have grown more than 80%. At the same time, dividends, wages and capital expenditures all rose, but at a lower rate than profits. The result: more cash.

In Canada, corporate cash holdings have doubled over the past decade, surpassing the $600-billion mark. Meanwhile, the global economy is still sputtering along, and employment growth is stagnating, causing those high levels of cash to draw heightened attention and criticism by governments, shareholders and the media.

So are corporations actually hoarding cash at the expense of lower investment returns for shareholders and the economy?

Business scholars have long urged business managers to hold less cash and assume more debt. But from a company’s point of view, it makes sense to increase cash buffers, especially after enduring a post-crisis credit squeeze.

How much is enough?

Firms need cash to perform daily operations, such as purchasing inventory and paying employees, and to cover unanticipated expenses. Having cash also provides the luxury of time, so companies can wait to select only the best projects.

But philosophies differ on how much cash companies should hold. Some proponents believe 2% of revenues is the right amount, while others believe cash is in excess if it’s above the industry average.

It turns out there is no magic number. Cash is in excess when it is unnecessary for ongoing operational needs.

A company’s cash holdings need to be examined on a case-by-case basis while taking into consideration unique needs, such as cyclicality and planned capital expenditures.

What to look for when investing

So where’s the best place to put your money to work? Invest in businesses that are responsible cash managers.

Find a company with a team that has generated returns above the cost of capital, and has ultimately created value for shareholders over the long term.

When it comes to cash, too much of a good thing can be dangerous. Having excessive amounts of cash has the potential to render management lax and encourage imprudent acquisitions and spendthrift expansion. Steer clear of businesses where management has an overall poor record of capital allocation — no matter how good the share price.

Look for dividend payments and share repurchases that are made only when it is responsible to do so. This entails repurchasing equity when shares are undervalued and paying dividends only when it’s not at the expense of efficient business operation, promising growth opportunities or an adequate liquidity position.

Companies rarely tinker with dividends. Cutting them is considered a desperate move, although it might be the right move. At the same time, don’t shun companies that have cut dividends without digging deeper to determine if it was a short-term glitch, and the company has the possibility to recover. If so, it may be a great time to pick up the stock of a long-term investment at a discounted price.

Despite these concerns, the transition towards higher cash holdings and liquidity is a positive sign of healthy corporate balance sheets. Most importantly, it has not hurt returns for investors.

Nevertheless, as an investor, you’re better served by having fewer dollars today but owning a share of a business that has greater value, as well as the ability to pay substantial dividends, in the future.

Can we trust cash-flow statements?

Figures on the cash-flow statement are merely adjustments of numbers that come from the income statement.

Income figures are based on numerous management assumptions. In short, management estimates what expenses belong in the quarter in order to match them to their estimate of how much revenue should be recorded.

Actual cash-flow figures do not match up to revenue and expense estimates. Sometimes cash comes before revenue, sometimes after; the same goes for expenses.

The period in which “cash” is recorded on the cash-flow statement can be completely disconnected from actual cash flows in and out of the bank. That’s the first big miss when it comes to the cash-flow statement; the second is when it comes to categorizing cash flows. The cash-flow statement is divided into three categories of cash: operating, investing and financing. The problem is that cash can be miscategorized by management or, alternatively, misinterpreted by investors. Investors place significant emphasis on cash from operations and/or free cash flow. Unfortunately, this is akin to looking at only about one-third of the information on the cash-flow statement.

–Al and Mark Rosen