Cash management is a critical job that many business owners undertake from an emotional perspective. Poor cash management can harm the company’s performance in both subtle ways and obvious ones. Problems do not just arise from a dearth of cash; having too much cash can also negatively affect a business. Holding excess cash can be like increasing the cost of goods without an increase in prices.
Excess Cash Explanation, Effects, and Consequences
Increasing or decreasing excess cash balances is an important indicator of your company’s well being:
- If there is insufficient working capital cash and decreasing cash generation, cash needs to be accumulated
- If, however, there is excess cash balances and increasing cash generation, the excess cash needs to be invested or distributed
Excess cash has 3 negative impacts:
- It lowers your return on assets
- It increases your cost of capital
- It increases overall risk by destroying business value and can create an overly confident management team
When your cash balance exceeds your actual working capital cash balance need, you have excess cash, or cash that is not necessary to the firm’s financial operations. Let’s look at the effects of excess cash one item at a time, starting with Return on Assets (ROA).
For this example, we’ll use a business with total assets of $1,000,000 and cash making up 15%, or $150,000, of that total. Let’s say this business has an annual after tax net income of $100,000, which equates to an overall ROA of 10% ($100,000 / $1,000,000). If the business is only earning 2% annual interest on the cash portion of the total assets, then the real effect of cash can be determined. For illustration purposes, we assume that all of the cash is excess (in other words, not earmarked for other projects, improvements, etc).
If the return on the cash is 2% and the overall ROA is 10%, then we know that ROA would be higher if the cash could be eliminated from the total assets. With the cash eliminated, total assets go from $1,000,000 to $850,000, and the interest income on the cash is eliminated, along with the net after tax income of approximately $2,000. The new total net income after tax is now $98,000, and that amount divided by $850,000 (total assets) results in a new ROA of 11.5%. By eliminating our excess cash, our ROA is 1.5% higher, an increase of 15%.
The second effect of excess cash occurs simultaneously in the scenario above: excess cash increases your Cost of Capital (COC). Using the example company above, lets assume the weighted COC is 15%, a common percentage for mid-size, privately held companies. With a COC of 15% and a ROA of 10%, this company is losing money on invested capital! It would be like selling your products at less than what it costs to make them. No one would purposefully do that. Lowering the cash portion – typically equity financed – lowers the most expensive portion of COC. In our example it lowers the COC to about 13%, closing the gap between the ROA and COC.
When the COC consistently exceeds the ROA, the overall risk of the business goes up and it slowly bleeds to death. This situation results in a constant destruction of capital and increased risk by restricting the company’s access to capital. It also lowers its market value relative to book assets and book equity while increasing its real debt burden (if the company is financed).
The final effect of holding excess cash is over-confidence on the part of management, commonly deluding management into feeling infallible. With so much money in the bank, what could possibly go wrong?
But excess cash is an example of past success, not future capability. Holding excess cash means that management can fix their mistakes with the cash instead of working their way out of the problem. The reason for this is the excess cash will bury the mistake so that in-depth analysis of the problem or failure is not assessed. Companies with a lot of excess cash consistently overpay for acquisitions – in the name of investing cash – which destroys the company’s market value.
Do not fall into the excess cash trap! Save your ROA, COC, and management decision-making process by keeping an eye on how much cash you hold.
Excess Cash Example
Having a lot of cash in our bank account feels great, but imagine having ten times that amount. How would that affect your financial decision-making? Would you use part of it as a down payment for that nice car you’ve always wanted? Would you skip the negotiation process for that car, knowing that the impact would not be as heavy? Would you still take the time to shop around for the best interest rate?
Let’s say you’re a little more frugal than that and decide that the money should simply remain in the bank as a safety net. When you read your bank statements, you feel better knowing that money is there in case something goes wrong.
But are you as safe as you think?
Perhaps not. Your savings account is not immune to inflation. Every year that this cash sits around making you feel better, it loses value through inflation. Even if you were able to find an interest rate that paces inflation (typically between 1.5% and 3.5%), this cash is a non-productive asset. While your cash is devaluing (or remaining stable):
- … you are accruing interest on your credit cards, car, and house
- … you are potentially causing yourself stress with a job that you don’t like, a house that needs upgrades, or a car that breaks down regularly
- … you are missing out on opportunities to create an even better safety net through a 529 account for your children, stable bond investments, or an IRA account.
Having more cash on hand than we need can create a false sense of well-being by increasing our confidence level, and decreasing the opportunities we have to create better financial stability.
The balance between too much cash increasing overall risk and not enough leaving you vulnerable is delicate. Our monthly analysis program can help you keep the right amount of reserves on hand while taking advantage of important growth opportunities created by strategic spending.