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
Bad Reasons for Extra Cash
Is it possible for a company to have too much cash? ›
While companies love to have cash, sometimes they hold too much 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.
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? ›
If you're actively measuring and managing the financial drivers of the business you'll soon realise if you've got excess cash. This is because you'll start to experience the symptoms of a “lazy” balance sheet – a falling return on capital employed (ROCE). More cash means you have to make an appropriate return on that.
How to determine if a company has too much or too little cash? ›
Prospective financial reports for the next 12 to 18 months can be developed to evaluate whether your company's cash reserves are too high. For example, a monthly forecasted balance sheet might estimate expected seasonal ebbs and flows in the cash cycle.
Is it good if a company has a lot of cash? ›
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.
Is 100k in cash too much? ›
If you're going to need $100,000 or more in the near future, then it's fine to have that much money in your savings account. There's one situation, in particular, where people often need this much or more in savings: when they're planning to buy a home.
What is the maximum cash amount allowed? ›
YOU ARE ALLOWED TO CARRY AS MUCH CASH AS YOU WANT OUT OF AND INTO THE UNITED STATES. To summarize up front: no, you are not restricted to traveling with sums of $10,000 or less. In fact, you could travel with a checked bag stuffed to the brim with cash — as long as you declare the amount beforehand.
How much cash should a company have on hand? ›
So exactly how much cash should you have on reserve at any given time? When it comes to cash-flow management, one general rule of thumb suggests enough to cover three to six months' worth of operating expenses.
Can I deposit $50,000 cash in a bank? ›
Banks must report your deposit to the federal government if it's more than $10,000 to alert the federal government to monitor for potential financial crime.
There are no rules which state how much cash you can have within your property, however there are some very good reasons why holding large amounts of cash at home is not a good idea.
What is a potential reason for a company to hold excess cash? ›
Companies hold cash for various reasons. Whether due to geopolitical tensions, a divisive domestic election, or high inflation, many business owners and managers are holding onto cash because they remain cautious regarding their industries or the aggregate economy.
How do you know if a company has enough cash? ›
The net cash flow figure for any period is calculated as current assets minus current liabilities. Ongoing positive cash flow points to a company that is operating on a strong footing. Continued negative cash flow may indicate a company is in financial trouble.
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.
How much cash should be left in a business? ›
How much is enough for a good cash reserve? The accepted wisdom is that you should have three months' working capital in an accessible bank account. Your working capital is stock and short-term debts owed to you, minus short-term liabilities that you owe to other people.
How do you identify excess cash? ›
To calculate cash excess, you need to assess your company's current financial statements. Begin by determining the cash balance at the end of a given period. Then, subtract the cash amount required for immediate operational costs, upcoming payments, and planned investments.
Why would companies hold a lot of cash? ›
Finally, holding large amounts of cash also allows firms to signal their investment prospects to the capital markets. Investors may incorporate an optimistic outlook, thereby bolstering the firm's overall valuation and reinforcing the importance of cash as a strategic asset.
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 would a company have a lot of cash on hand? ›
Having cash on hand, or money that is reserved in case of an unexpected event, can keep a business running when funds are tight or allow them to take advantage of unforeseen opportunities such as a large expansion or investment opportunity.
How much cash is too much cash? ›
There's no one-size-fits-all answer to the question of how much cash is too much. The ideal amount depends on your individual circ*mstances, financial goals and risk tolerance. Talk to your financial professional today to find just the right strategy to help make your retirement remarkable.
