When is there excess cash on the balance sheet?
That seems a strange question to ask at a time when treasury departments are confronted with decreasing operating cash flows, capital market access constraints, and demands from their CEOs to take on bargain investment opportunities during the current financial crisis.
Eventually shareholders will remember that cash on the balance sheet might not all be for the best. So bear in mind that excess cash might still exist, and reflect on what this means for your company. This article tries to support corporate treasury and finance executives by taking a look at the academic foundations regarding excess cash.
Empirical research on excess cash holdings—cash at hand and marketable securities not required for operations and capital investments—centers on several issues. This article examines two. First, excess cash can only exist if there are target cash levels that can be exceeded. Hence, can academics find evidence for target cash levels and support for their existence? Secondly, theory has devised the concept of managers wasting company resources if those resources are available in the form of excess cash. Academic research established that good governance does not avoid excess cash occurring, but that it does avoid excess cash being spent in value dilutive ways.
Does an optimal cash position exist?
This question is investigated by testing hypotheses on how a company's cash position should change given certain management actions. For example, the cash position of a company might be lower the higher the operational cash flow of the firm because generating lots of cash does not require large cash holdings. However, the cash position of a company might also increase the higher the operating cash flow simply because cash inflows exceed cash outflows. The former hypothesis supports the trade-off view of cash holdings, i.e. the view that management proactively tries to achieve target cash levels, and hence that an optimal cash level exists. The latter hypothesis supports the financing hierarchy view, i.e. that a firm's cash holdings are a residual result of management activity. Consequently an optimal cash level does not exist. The evidence found is inconclusive, as there is support for both concepts. From the academic perspective, it is unclear whether an optimal cash balance for a company exists and thus whether excess cash can occur.
Financial theory finds two motives for management to hold cash -- the transactions motive and the precautionary motive. The former reflects that management has to reserve cash for short-term working capital needs. The latter reflects that, in imperfect markets, a firm will hold cash in order to enable future investments as well as to prepare for (un)anticipated operational cash shortfalls or capital market access constraints. Theoretically, these two motives should determine an optimal cash position for the firm. Academic research uses proxies for these two motives in order to determine target cash holdings.
The main cash determinant reflecting the transactions motive is working capital net of cash, as a lack of cash can be compensated for with a decrease in other current assets. The main cash determinants reflecting the precautionary motive are market-to-book ratio, company size and operational cash flow. Companies with ample investment opportunities, represented by a high market-to-book value, hold more cash since they would like to secure cash availability at the optimal time to invest. Large companies need to hold less cash as they have greater access to capital markets. Finally, as mentioned before, there are different ways of looking at the association between cash holdings and operating cash flow. Also exogenous influences on cash holdings are investigated, broadly centered on the state of the economy, commercial and financial market structures, as well as the legal and governance framework.
The target cash position of a company is established by regressing the firm's cash balance against these determinants of cash holdings. The amount of excess cash held by a firm is the difference between its actual cash balance and the target level. A major result from these investigations is that cash holdings seem to be persistent, i.e. that if a company holds excess cash it does so not only once, but over a period of time. Another finding is that credit lines might be held for future investments whereas excess cash might be held as a buffer for future cash shortfalls.
Do managers waste resources when excess cash is available?
This question is investigated by linking certain management activities to cash holdings or to the value of holding cash. In general, there is more evidence for than against the hypothesis that management might squander money if weak control is exerted on them. We find three main clusters of investigation:
- Evidence from the market of corporate control mainly supports the concern that excessive resources might be wasted. The likelihood of proxy fights increases with cash holdings and the value of cash decreases with higher cash positions in companies with weak shareholder protection as well as with controlling shareholders having the opportunity to generate private benefits from parts of a firm's cash holdings.
- There is inconclusive evidence with regard to the investment strategy and the corresponding operating performance. While on the one hand evidence is found for poor governance leading to dilutive investments and subsequently suboptimal operating performance, other studies find companies with poor governance holding more cash and having no significant difference in operating performance compared to cash rich firms.
- From the governance perspective, there is more evidence in favor of the agency theory. In general, the majority of the scholarly papers find good governance increasing the value of cash with the value of a dollar of excess cash seen at a range of 42 cents to 89 cents for poorly governed firms with a doubling of this value for well governed companies. Evidence is found that shareholders of weakly governed firms prefer dividends over share repurchases or, put differently, the cash value in weakly governed firms is lower in case the company redistributes cash to shareholders through stock repurchases as opposed to dividends. Also, a U.S. cross-listing is used as proxy for better governance and, as expected, higher cash values in U.S. cross-listed companies are found compared to not-cross-listed ones.
Academic research does not provide conclusive evidence for the existence of optimal cash levels. Also, if a dollar on a balance sheet is valued at less than a dollar by shareholders, academic research has not concluded that this means corporates have excess cash on their balance sheets, as intuitively right as it may sound. However, there is still evidence that actions management can take to optimize the firm's cash value.
The checklist in Figure 1 proposes perspectives one could take in order to find such opportunities. Ensuring that potential bidders for a company as well as current shareholders understand the value of a company's cash position might optimize the share price as well as potential bids for acquiring a firm. An additional benchmark helping in that process might be the cash position of competitors. Finally, the hygienic factor is the optimization of operational performance in the entire value chain as well as through negotiating optimal credit lines.
Luc Soenen, is Professor of Finance at TiasNimbas Business School, Tilburg University in the Netherlands and at CENTRUM Pontificia Universidad Catolica del Peru. (DBA Harvard University, MBA Cornell University). Nils Backhaus is a doctoral candidate at Bradford University in the UK.
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Opportunities to improve company value through management of cash value