I recently read an article on CNBC titled, ?Too much cash on books should be a red flag for investors?.
The author underlined that despite cash usually being a good indicator of corporate health and being a safety net for emergencies, too much cash can actually be detrimental to shareholders? value. This is because the cash on hand is not providing shareholders with sufficient returns on equity if it merely remains as cash and is not being used.
This is contrary to popular belief that cash is the lifeblood of the business and having more cash is a good thing rather…
I recently read an article on CNBC titled, “Too much cash on books should be a red flag for investors”.
The author underlined that despite cash usually being a good indicator of corporate health and being a safety net for emergencies, too much cash can actually be detrimental to shareholders’ value. This is because the cash on hand is not providing shareholders with sufficient returns on equity if it merely remains as cash and is not being used.
This is contrary to popular belief that cash is the lifeblood of the business and having more cash is a good thing rather than a bad one.
Lower returns on equity
The main argument when it comes to hoarding too much cash is that companies have a lower return on equity versus companies with less cash. This is because companies are unable to generate high returns when cash is left as deposits. The current low-interest rate environment means that companies who sit on cash can only generate about 1-2% returns on that capital.
On the other hand, companies that use their cash for investments and expand their business should be able to generate substantially better returns if the cash is put to good use.
Pressured into making unnecessary acquisitions
Another problem the article states is that companies are pressured into making unnecessary acquisitions when they hold on to cash. This could be due to shareholder pressure or advise from investment banks that stand to gain from each acquisition.
If a company has too much cash, managers may also start to become careless and risk spending the money recklessly, in order to pursue their own agenda.
But there are times when sitting on cash is a good thing
Having a lot of cash, however, can sometimes be a good thing for companies and investors. Companies that are run by prudent managers, who know how to put the capital to good use eventually, can benefit from having the extra liquidity.
Warren Buffett’s company is a great case in point. As of the second quarter of 2017, the company is holding on to around US$20 billion in cash and another US$66 billion in short-term US treasury bills.
However, investors are not fretting over the loss of opportunity costs as they are confident that with Charlie Munger and Warren Buffett at the helm, the capital will be put to good use eventually to increase shareholder returns.
The same could be said about the late Steve Jobs’ company, which is currently sitting on around US$256 billion. The company is extremely well managed and is very careful with its investments. Investors, therefore, should be happy that it has cash on hand, as they know that the money would be used wisely in the future.
The Foolish bottom line
Having too much cash may sometimes cause management to end up making rash decisions that result in weaker shareholder returns in the future.
However, cash can also be a good thing if management is prudent and uses the money wisely. Investors, therefore, should not blindly take that hoarding cash is a bad thing but assess if the management team is capable enough to make the extra liquidity count as an asset, rather than a liability to shareholders.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.