Ever since I started writing these mini-lessons, I’ve focused on the importance of cash flow, cash reserves (savings), and cash utilization. And while these are certainly vital topics in understanding ongoing corporate finance as well as business growth (and its limiting factors, in the case of “Can a Company Grow Too Fast?“), there is indeed a flip side. Many companies never achieve the financial breathing room required to even wonder if they have “too much” cash, and while it’s a much better problem to have than not enough, a large enough stash can indeed be a negative for a company’s finances. Today, I’ll share a couple of reasons why that’s the case.
1) The company isn’t reinvesting in itself enough
In many ways, corporate finance can be understood using similarities to personal finance. In personal finance, it’s always good to have an emergency fund. You want to save up a financial cushion for when a car needs repairs, when the air conditioner goes belly up, or someone is unexpectedly let go. Savings are wise not only for emergencies, but for general liquidity — a “finance-ese” term for being able to access cash easily for whatever reason.
But cash, even though it feels good and secure and stable, is a terrible vessel for large percentages of your money. Due to inflation, cash actually declines in value over time. Even if it were stable and never lost value, almost nobody has both the income and the financial discipline to save 50% of their earnings for retirement. Once you’ve built up some emergency cushion and some “general liquidity” savings, there are better uses for your money. Debt should be paid off, because it works against you at whatever the interest rate is. You should also invest, since over the long-term, good investments will outpace inflation and actually make you money.
For companies, it’s very, very similar. Cash is great, because companies have emergencies and experience unplanned events just like you do in your personal life. They also get opportunities for things to buy that might not be necessary, but that are beneficial to have.
But at some point, that cash is just rotting away when it could be doing something. In the case of a business, that “something” is usually obvious: if we put that money back into the business, via equipment, or marketing, or personnel, we would expect to get a rate of return equal to our profit margins on that money. Or we have debt that, just like personal debt, works against us at whatever the interest rate on the loan is.
Cash for the sake of cash is worthless. If it’s not protecting against the unknown or allowing rapid response to emergent opportunities, it might as well be put to use to eliminate debt or invest in endeavors with some level of return.
2) The company expects a dimmer future
Last summer, when I was young and naive and finishing my MBA, I learned about the “harvest strategy.” The harvest strategy is employed when a business (or part of a business) has matured to a point of saturation, and there is little or no growth opportunity remaining. In this case, reinvestment is foolish; there’s no growth, market share, or profitability to be gained by pouring extra cash in, so instead, we’ll just rake in the rest of what we’re making and move on. In the case of diversified companies, that money might be channeled into another product line or division. In the case of small companies or those specific to a single product or industry, they may just save up the cash until they close the doors and withdraw their wad.
If industry, market, or competitive trends remove the benefit of reinvestment, cash becomes a more attractive option. Cash also becomes a more attractive option if the business is souring. Most likely the only reason my dear BlackBerry still exists today as an independent company is because ex-co-CEO Jim Balsillie kept the company debt free and cash rich (for an interesting business biography on the rise and fall of BlackBerry, I recommend Losing the Signal, by McNish and Silcoff). Again, using similarities to personal finance, if your company has announced layoffs, it can be prudent to save as much as possible in order to deal with the temporarily heightened uncertainty.
However, both of these options are reserved for companies in decline. If a company’s cash reserves are growing and analysts are asking what the plan is, you want to listen closely. The responses can indicate what the leaders of the business think about their future — vital information to anyone interested in the company, from an investor or an employee standpoint.
3) The company becomes a takeover target
There are about a thousand similes I could use here to illustrate this, and none of them are particularly kind, so grant me some leeway. At times, big companies can be like schoolyard bullies. If they see a smaller kid carrying around a lot of cash (or maybe a particularly desireable lunch), they can strongarm the victim and use it for themselves. Sure, they could pick on a kid with a nice, expensive backpack or a pair of high-end shoes that they could take, resell, and come out with the same gain, but that’s a whole lot more work. If they can get what they want directly, it’s to their benefit.
That’s a weaker analogy than I usually come up with. Sorry for my shortcoming. Big companies are not necessarily mean-spirited, and takeovers are not necessarily hostile or singly beneficial. But hopefully it’s good enough to illustrate the point.
If a company has too much cash, due to underutilization, declining business, or just lack of direction, well, somebody else can use that money better. Instead of letting it waste away in the corporate coffers, they’ll put it to use. In fact, since they’re the new owners of the company, maybe they’ll just reinvest it to get returns equal to the company’s margins, as mentioned before.
Apple is famous for its cash hoard, but then, they’re also basically immune to takeover at this point because of their growth rate and profitability, as well as their multiple hundred billion dollar valuation. But a small or medium company with a big loaf of cash can start looking really tasty to bigger fish.
4) The company isn’t rewarding shareholders
A top goal for any company is to make money for its owners. If the company is publicly traded, that means that the owners of its stock are the “real” ultimate owners of the business. While it’s in everybody’s best interest for the company to keep enough money to operate and grow, at some point, if the business is working well, some of that money should go back to the owners! Whenever the fundamentals are in order and the company clearly has the income to maintain business as usual and grow at a healthy pace, shareholders will start asking for a cut of the profits they’re entitled to. For a more thorough discussion of some of the ways companies can give back to their shareholders, see this article.