How much cash does a company need?

There is widespread evidence of companies hoarding cash these days.  Given the risk levels in the environment, it is natural for companies to want to keep a little something for a rainy day.  This is especially true for younger, unproven companies and high-tech companies – where the risk levels are higher and the ability to raise funds (in case of a crisis) may be limited.

One study for US companies (quoted here) suggests that the cash-to-asset ratio for companies has more than doubled between 1980 to 2004 – going up from 10.5% to 24%.

You’d think that 24% is a pretty large number as an average – but the report points out that number is skewed by some large companies like Exxon Mobil, GE, Microsoft, Apple, Google, Cisco, Johnson & Johnson, Verizon, Altria, EMC, Disney, Oracle.   Tech companies have an average cash-to-asset ratio of 27%, with Google at a monstrous 58%.

So it’s not necessarily the small, tech startup that’s raising the average (27% vs 24%).  It’s probably the big old economy players.   And I haven’t yet seen evidence of the stock-market punishing them for that (unlike what we read in B-school).  It really seems to be a case of everyone (with the ability to) trying to hoard cash.

Closer to home, Indian IT services firms have been traditional hoarders of cash.  So I did some quick numbers on them.  Even by their standards, the pile-ups seem to be phenomenal.  Between 2006 and 2010, Wipro’s cash/asset ratio has gone up from 13% to 24%.  TCS from 3% to 22%.  Infosys went up from 48% to 51% in 2009 and is now “down” to 44%.

You could argue that cash/asset ratios aren’t the best metrics for a services company – where the risk levels and uncertainty are lower than for product companies.  What you should look at is cash/operating expenses – how many month’s oxygen does a company have if all it’s revenue streams run dry.  There again, Infosys is up from 54% to 71% (about 8 months of expenses).  Wipro from 13-24% (3 months) and TCS from 2 to 21% (2.5 months).

So the question is how much cash does a company really need to keep on its balance sheet?  One could make several arguments about how the big IT companies could do with lower cash reserves (most of them are also quite unleveraged and have pretty significant real-estate assets).  However, it doesn’t seem like the stock market cares much for this ratio – and may actually reward cash hoarding tendencies!  There are many theories out on the subject, but the unifying argument seems to be missing.

Let’s see how things change once the recovery is more certain.. watch this space.

10 Responses to How much cash does a company need?

  1. Amit, in this economy, Cash is King! If there are no suitable investment avenues, its best not to waste the money.

  2. amtgrg says:

    Yes, but how much cash 🙂

  3. As much as one can hoard, I suppose! 😉 The real question is…how much cash should a company waste? The answer is Zero!

  4. Raj Bhatt says:

    Indian IT companies are well known for not investing money/resources/cash into R&D activities. One of the Infy board members was on air 2 days ago boasting that they had invested $12 MM this quarter in R&D. $12 MM for a multi-billion $ company !!

    That is why many of them are stuck in organic growth land whereas other companies (like Cognizant, IBM) are growing by leaps and bounds by acquiring capabilities/ customers/IP through M&A.

    I’m curious to see how traditional Indian IT companies invest/return their cash… or maybe they’ll employ Paul the Octopus to invest their surplus.

  5. Yeah, I could agree with you when it comes to IT companies. However, when we talk about manufacturing sector, and esp. SSI(s), the situation is totally different. These are always cash strapped, and have limitations on borrowings and being able to create long term debts. Have you some analysis on these companies too- that could be interesting.

  6. amtgrg says:

    I agree. Anyway, for private companies it’s immaterial – the money belongs to the promoter group – and if they want to keep it in the company, its their prerogative. For public companies, however, it’s shareholder money being deployed at FD rates (at best) – and if that money is not really required, it represents a fairly inefficient use of capital.

    If one is looking at a practical number for cash on the books, I’d imagine its the sum of the investment plan, expected increase in working capital and a safety stock for a rainy few months.

  7. Striking data, Amit.
    How much of this do you think is due to the law of diminishing returns? As companies gets larger, it becomes harder to find proportionately as many high ROIC opportunities (even if external economy held constant), and hence no option but to hoard cash.
    This appears to be especially true of high growth tech companies like Google and Apple – you can hope to get an ROE of 33% (AAPL’s ROE) on a few small investments, but there aren’t that many opportunities – M&A or organic – to invest $25B (AAPL’s cash position) for an ROE of 33%

  8. Amit – the other reason why IT companies might be hoarding cash is to fund acquisitions. Which have been pretty anemic and so the cash just sits there. Infosys has from time to time tried to do a special dividend or something to reduce their cash hoard. The special dividend achieves that goal, while not setting an expectation of a higher dividend rate in the future. It would be interesting to look at dividend payout history for Indian IT majors.

  9. amtgrg says:

    My hypothesis is that they haven’t been able to use cash in any meaningful way – no really big acquisitions (except HCL), no significant investments in R&D, no jamshedpurs being created etc. Neither have they really needed the rainy day reserve – variable salary structures, attrition (which reduces some of the stickiness of labour costs), subcontracting etc on the people side. Bad debts or days of receivables haven’t gone haywire. No big legal issues that I know of.

    So, an inability to use the money and no real need to hoard it. In fact, you could also argue that there should be scale benefits in cash requirements – since there are some internal risk/variability cancellations. Finally, it shouldn’t be that difficult for any multibillion dollar to raise money if needed (for, say, that mythical acquisition)

    Yet the piles have grown bigger. Will look for some more stats on this…

  10. Pingback: Apple and it’s money « Two MBAs, One Blog

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