Excess Cash – What Is It and What To Do With It

Do you think it’s best to hold as much cash as possible? Most business owners think the more cash the better (Apple, we’re looking at you) but that’s not the best move.

It’s best to either redeploy your cash in your business or take it out of the business to invest elsewhere, even if your business has to borrow cash with interest expense. Using Return on Assets (ROA), one of The Business Ferret’s 12 key financial metrics, we can easily see why it’s best to invest.

Imagine your firm holds $500,000 of total assets, including $100,000 in cash. Given current low interest rates, let’s assume your cash is earning 2% ROA (after tax), or $2,000 annually. Your business should earn a higher return on total assets than it earns on cash balances, so let’s assume your business is earning 12% ROA (after tax) on total assets including cash, or $60,000 annually.

It’s not hard to see that if you redeployed your cash in your business, then your firm’s annual ROA on that $100,000 would increase from 2% to 12%, increasing earnings from $2,000 to $12,000.

But what if there’s no redeployment opportunity in your business? This is the point at which most business owners stop analyzing and sit on the cash, but we’ll use ROA to look further.

If you take that $100,000 cash out of your business and instead use a line of credit for intermittent cash needs, your ROA will increase. Still assuming your business has an ROA of 12%, or $60,000 return on $500,000 of total assets, removing the cash would increase your ROA to 14.5% ($60,000 minus $2,000 of interest income divided by $400,000 total assets).

The cash is dragging down your ROA by 17%; without it, your return would be 21% higher!

Are you complaining, “But now I have to pay interest”? Even if you borrow the entire $100,000 for a whole year at 7% interest, your after-tax cost would be $5,000. Subtracting $2,000 of foregone interest income and $5,000 of after-tax interest expense from your $60,000 ROA, your company earns $53,000 in after-tax income. Dividing by $400,000 in total assets, you produce a 13.25% ROA, still up from 12%.

By taking that $100,000 cash out of your business, you are free to put it in a higher-ROA investment. The main issue, though, is that you reduce the risk of your overall asset holdings by diversifying your investments. Even if you put your cash in the same bank at 2% ROA, by taking it out of your riskier business asset, you will have reduced your overall risk.

Still want to hold onto that cash?