We all know that debt can signify many things; and most of them are bad. With debt comes uncertainty. It’s a liability. And while a company can leverage debt for growth without spending valuable equity, it also takes on a lot of risk, which can impair long-term viability.
So if debt is dangerous, is a large amount of cash the answer? A strong cash position provides options. It’s protection against uncertainty. But as we’ll see below, it can also signify carelessness and lack of strategic planning, particularly at the management level.
Why have cash in the first place?
Often, cash can indicate strong revenues and high margins. It can also be a result of a business model that requires less capital-intensive investments, like service industries or software, where the cost of doing business is much lower than an industry like manufacturing or aviation. In these scenarios, a cash reserve builds up quickly, and can often create the dreaded, unspoken “opportunity costs.”
What’s the price of opportunity?
At its core, cash truly is opportunity. It’s the chance to grow, invest, re-invest, or reward shareholders with dividends for their loyalty. Corporate finance textbooks say that companies ought 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. The current ratio and the quick ratio help you determine whether companies have enough coverage to meet near-term cash requirements. But beyond that, cash needs to be used.
If it’s not, that’s called opportunity cost, or the price of letting your cash do nothing. If it’s a permanent feature of your company’s books, it may be time to ask yourself why. Does management not see it? Are they not thinking strategically about the growth of the business? Are they not finding opportunity? A company with a lot of cash is only growing that value as fast as its interest rate, which in a competitive marketplace, isn’t that fast at all. Reinvesting in operations, employees or even investors can provide long-term gain well beyond the return of a savings account.
How can you turn cash reserves into business insight?
If you’re a management consulting company, a large amount of cash could signal opportunity. It could be time to reach out to a company and inquire what’s keeping them from investing.
If you’re in investment banking, a company with large cash reserves may be saving for an acquisition and may need M&A support. They may not want to issue stock if management perceives current stock to be undervalued. An acquisition can also be interesting competitive insight.
If you’re a vendor or service provider, a large amount of cash could also indicate preparation to spend on a large project, and it could be worth reaching out to this company as a potential sales prospect.
Or, if you’re a competitor, this cash could indicate an executive team that’s in trouble. When combined with other disclosures in the footnotes, cash can begin to paint a picture of a company in distress, without long-term vision.
By scrubbing the public data in the marketplace, there is plenty that your team can infer from the companies that it deals with or competes against. Check back here regularly for more insights in the data.