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While investing,don’t go by company’s cash pile only

Making money from equities is never easy.

Published: June 11, 2013 12:31:44 am

P Saravanan

Making money from equities is never easy. It becomes more difficult if the market is

directionless,as it has been for the last few months. One way to handle such a situation without taking too much risk is by investing in companies with good cash reserves. Apart from a company’s bank balance,their investment in short-term investments is also considered as equivalent to cash. Cash-rich companies have an edge over others as they can use the money to spur growth,

resulting in increasing the shareholder value.

Companies can use the cash to reduce their debt or increase capital expenditures. During recession,when most companies find it difficult to sustain themselves,cash-rich firms can operate easily. They also find acquisition opportunities as many firms are available at a discount due to the low business sentiment. Cash-rich companies are considered especially safe during periods of crises such as low liquidity,foreign institutional investor exits and high-interest rates. So,cash offers protection against tough times and it also gives firms options for growth.

The general perception is that shares of cash-rich companies face less downside risks when there is a correction in equity markets. It is not always the case.

Reasons for holding cash

Companies hold cash for two motives: transaction and precautionary. By and large,retail firms are likely to maintain higher balance in the last quarter of each year,reflecting higher sales they anticipate around the holiday season. Under transaction motive,cash is held to meet the needs that arise in the course of doing business. In contrast,firms hold cash to meet contingencies and unforeseen needs. Both the needs are likely to vary across the industry. Firms that can borrow easily and at low cost are much less likely to keep large cash balances to cover unexpected events.

Opportunity costs

Each company has its own optimum cash balance,and companies are expected to keep just enough cash to cover their interest,expenses and capital expenditures; plus they should hold a little bit more in case of emergencies. Generally,current ratio and quick ratio help investors identity whether the companies have adequate coverage to the short-term obligations. Having an excess cash is an expensive luxury because of the opportunity cost,which is the the differences between interest earned on holding cash with the company and the cost of the capital of the firm.

For instance,if a company’s weighted average cost of capital is 14% and the interest earned on the cash is 4%,the opportunity cost is 10%. If a company can get 22% return on equity investing in a new project or by expansion or diversification,it is costly to keep the cash in the bank. If the project’s return is lower than the company’s cost of capital,then excess cash should be returned to shareholders. Companies that hold excess cash can fritter away cash on wasteful acquisitions and bad projects in a bid to boost power and prestige. Large cash holdings also remove some of managers’ pressure to perform.

Over a period of three years,the manufacturing industry enhanced its cash holding by 170%,followed by construction and real estate to the tune of 99% (see table for cash holding pattern among various industries). But at the same time,if we observe the return from these industries during the same period,definite conclusions can’t be drawn whether increase in cash holding leads to increase in return to shareholders.

Companies in sectors like software and services,entertainment and media don’t have the same level of spending as capital-intensive firms. So their cash pile builds up. Contrary to this,companies with huge capital expenditure,like steel makers,need to invest in equipment and inventory,which must be regularly replaced. Capital-intensive firms have a hard time maintaining cash reserves. Investors should recognise,moreover,that firms in cyclical industries,like manufacturing,have to keep reserves to ride out cyclical downturns. They need to stockpile cash well in excess of what they need in the short term.

Investing purely on the basis of a company’s cash balance is not right. Investors must also consider a few other factors. Other than cash reserves,one should look at book value,price-to-earnings ratio,earning per share,price-to-book value,return on equity etc. Having a lot of cash may also indicate the company is not using resources properly. This can lower the return on equity. The best company to invest is the one that generates high cash flow and keeps increasing it year after year.

The writer is an associate professor in finance and accounting at IIM Shillong

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