What is not
so clear is whether this increasing cash pile – as outlined in Figure 1 below
showing trends in cash over recent years – is ‘enough’ to continue to pay
liabilities when they come due or allow the companies to compete against others.
After all having ‘more’ is not exactly the same as ‘enough’.
Figure 1: Selected Financials for US
S&P500 Non-financial Companies at 30 June 2013
Source: The
American Association of Individual Investors (AAII)
Whether a
company is cash rich or cash poor depends on how a company decides to match up its
sources of cash with uses, today and in the future. Also third parties, such as
investors and banks, get a vote. Examples include the following:
Apple
has over US$88bn in cash and cash equivalents on hand – more than most other
companies – yet was forced to borrow when an investor demanded that it pay
dividends.
Companies
such as Bear Sterns, Lehman Brothers and MF Global assumed they had enough cash,
until their counterparties actually started demanding it back.
Total
external debt for the S&P 500 has increased faster than cash. While not all
of this debt is due, immediately rising levels may give companies pause about whether
they have enough cash for operations today, the ability to fund business investments
and repay debt to in the future.
Cash
flows have been volatile and have been declining over the past few years. Lack
of cash flow and the spectre of future debt repayments could cause some
companies to defer spending to build more cash balances in the future. Investor
reaction to this balancing act could affect company values.
Most would
agree that cash on hand is just one of the components to consider when
determining if sources of liquidity match uses of that liquidity. Other
components of liquidity include the frequency and amounts by which cash
balances are replenished – either from an operating source (i.e. operating cash
flow) or by accessing the capital markets (i.e. financial cash flows); why
these liabilities were incurred (to achieve profits?); how they will be paid (from
operations? more borrowings?), when they will be paid and what must be sacrificed
to do so (priorities) – all can determine if the market considers a company to
be cash rich or cash poor.
Why is being
cash rich or poor important? Simply put, in a capitalistic environment cash
poor companies have less control over their business future because they are
more exposed to market forces and incur a greater risk that expectations will
meet actual results; cash rich companies have more control/more alternatives,
which allows them to generate more value over time for their investors. The
real issue is to understand what levels of liquidity are required to be
considered cash rich or poor.
An Individual Judgment
There is no
right answer to the issue of enough liquidity or too much risk. All is
relative; however, there are some profitability, liquidity and risk metrics
which can be used to as a ‘starter set’ to answer the question ‘is my company
financial successful?’:
Postive EBITDA: Earnings before interest, tax,
depreciation and amortisation (EBITDA) is a measure of operating earnings and is
prized by ‘the Street’ because more usually leads to increasing stock values.
It has its shortcomings since it assumes that borrowings/interest expense, foreign
exchange (FX) exposure and taxes are not important to a company’s operations
Positive free cash flow: EBITDA can be considered a forecast
of future operating cash flows, but if these flows are to be enough then they
must pay for ‘must haves’ such as capital expenditure (capex) and dividends required
to meet longer term business needs and investor expectations. With positive
free cash flow (i.e. positive operating cash flow less capex and dividends) a
company can think about other best uses, like paying down debt or acquiring complimentary
businesses. After all, a company that cannot produce enough operating cash flow
to re invest in its’ future is most likely in the wrong set of businesses and will
disappoint either its investors’ need for dividends or its banker’s
expectations of repaying debt when it comes due. Disappointments such as these
can make a company non-competitive or even threaten its existence in the long term.
Cash on hand: or trying paying your payroll with
‘profits’. Having the right levels of cash in the right currencies has many
benefits, such as giving management a stronger negotiating position with creditors
and vendors. How much cash to maintain on hand can depend on the length of a
company’s operating cycle and the duration of its liabilities.
Ability to borrow: Having access to more cash is almost
as good as having it on hand, although one’s borrowing capacity is often
determined by external parties rather than management. Also, there is a real
cost of borrowing which could vary based on market forces not under management
control. Most banks want their customers to maintain a low debt/equity leverage
ratio; however, investors can be less demanding if they believe that more financial
leverage leads to more EBITDA.
Length of cash conversion cycle: Companies that quickly purchase
process and then convert sales to cash while controlling the expense of doing
so can operate with less cash on hand because they are able to replenish/add to
that cash level in less time. Cash conversion cycle times can change,
especially if the company is stocking up for an expansion into new markets, or will
be introducing new products demanded by its customers.
After tax cost of funds: As with any goods, funds purchased
by a company should be procured at the lowest all-in cost over the time period
under consideration. The costs of funds should include costs to acquire funds
from third parties as well as the cost to ‘operate’ those funds by areas like audit,
tax and treasury, which are responsible for allocating funds to business units based
on best uses.
The Measure of Success
As
companies peer into the haze which represents the 2014 business environment,
their ability to declare ‘success’ will depend on management’s ability to
define, measure and manage results across its portfolio of businesses. Sometimes
the right definitions and the metrics to measure success can best be set by learning
from the ‘other guy’ (i.e. a company’s competitors). After all the correct balance
of profitability liquidity and risk needed to increase company value is as much
determined by management as by investor desires.
Figure 2
below shows which companies among the S&P 500 could be considered cash rich
/ poor by industry sector based on their 6/30/13 results according to the following
metrics that reflect an integrated view on profitability, liquidity and risk.
The list following the chart highlights the top / bottom 10 non financial
companies among the S & P 500.
Figure2: Who is Cash Rich or Cash
Poor in the S&P 500?*
*Based on
the 432 non-financial companies as at 30 June 2013
Source: The
American Association of Individual Investors (AAII)
Profitability: Positive EBITDA is a good indicator
that positive cash flow will occur, assuming that various assumptions about
sales, expenses and various accruals are accurate.
Liquidity: Positive fee cash flow demonstrates an ability to internally fund important uses of cash, such as capex and dividends.
Cash on hand – cash flow occurs over
time. Having cash on hand today insures current liabilities are paid promptly.
Companies often maintain cash levels in relation to current liabilities. This relationship
can be expressed in number of days. As of 20 June 2013 the average S&P 500
non-financial company had approximately 33 days’ cash on hand.
Risk: Companies often leverage their value
by accessing the debt markets to acquire funds now, rather than wait for them
to accumulate in the future. The market often looks favourably on the use of
this ‘force multiplier’ unless the ratio of debt to equity in the judgment of
the counterparties becomes ‘excessive’, potentially jeopardising the repayment
of these debts. As of 30 June 2013 the average S&P 500 non-financial
company had a debt/equity ratio of 1.3
Based on
the metrics above, Figure 3 highlights the companies within their respective
industries that could be considered cash rich or cash poor.
Figure 3: Cash Rich and Cash Poor
S&P 500 Companies by Sector
Source: The
American Association of Individual Investors (AAII)
Conclusion
There is no right answer about how much liquidity is enough except to say that
more liquidity allows a company to immunize itself from market forces that
could jeopardise its market value. Also, comparison to the competition about
how much liquidity is enough are inevitable and that ‘the market’ gets a vote
about who are cash rich or cash poor.
For those
planning for 2014 the important take away from this article is that liquidity
counts and metrics will be needed to measure results. After all, what gets
measured gets managed.
