The concept of “too much cash”
For a business to be profitable and efficient in its operations, it needs to realize and sustain a suitable balance between all the items in the statement of financial position. Maintaining an appropriate cash balance in the books of accounts is a challenge for many entities. This can be attributed to the fact that cash is beneficial because it is required to pay obligations. However, it is not productive. Thus, the company does not gain from holding “too much cash”. Accounting theories hold that, an appropriate cash balance that a company can hold depends on a number of factors such as the industry in which the company operates, the nature of products, the size of the business, and what the management intend to do with the cash balances. Thus, a company needs to hold an appropriate cash balance that is sufficient for daily operations and for emergencies. Current ratio and acid test ratios are the most common tools that are used by the various stakeholders to determine if an entity is holding too little, adequate or excess cash. The ratios provide information on whether or not the cash balance that a company holds can sufficiently cover the operations.
Accounting theories further maintain that a company that holds cash balances that are over and above the desired level should reallocate the excess cash balances to the equity capital providers (Collier, 2009). This can be achieved through payment of dividends or share repurchases. Thus, a company should not hold the excess cash balance for speculation. The “too much” cash balances depends on the industry in which a company operates. For instance, companies operating in industries that require large capital investment such as in the oil industry may find it difficult to accumulate a cash reserve. On the other hand, companies that operate in industries that do not require large capital investments or cyclical industries may accumulate cash. Examples of these industries are manufacturing, entertainment, and software among others. Thus, when evaluating the concept of “too much cash”, an analyst or an investor needs to take into account the industry in which the company operates. Large cash balances can either be good or bad for a company. A large cash balance may indicate that a company has a sturdy financial position. It may imply that the cash balance is accruing so fast and the management team lacks time and opportunities to spend the excess money (Lee & Suh, 2011).
Investors may be skeptical about deciding to invest in companies that hold “too much cash” balance in their books of account. These can be attributed to the fact that “too much cash” may be an indication of a looming danger on the financial standing of a company. First, a high cash balance may indicate that the management of an entity lacks prospects for investment. It may also indicate that the management team is not proactive. This implies that the team is not efficient. Secondly, holding too much cash is less profitable to the company (Grullon & Michaely, 2004). A large cash balance in the books of account is less productive because it has a high opportunity cost. For instance, if the cost of equity is fifteen percent, while the interest earned from keeping cash is at ten percent. This shows that holding cash will be less productive for the company. In another example, when evaluating projects if the return on equity from investing in a new project is less than the cost of capital of a company, then the project is not viable. Thus, the capital raised should be refunded to the capital providers. In a similar way, if a company holds “too much cash”, it implies that the company lacks viable investment opportunities and so shareholders should be refunded the cash.
The third reason why investors are often worried about “too much cash” is that it increases the agency cost (Jensen, 1986). In this scenario, the management team may invest in a project just because they want to build a kingdom and not necessarily because the project is viable. In this case, the management may use the excess cash balance to enhance their personal supremacy by investing in inefficient projects. This leads to low returns to the shareholders and erosion of shareholders’ wealth. In this case, raising capital from capital markets reduces the agency cost because all investment opportunities will undergo public and transparent scrutiny before the shareholders can contribute capital to such new projects. This eliminates the possibility of investing in wasteful projects. The fourth reason why the investors are worried about “too much cash” balance is that it encourages the management to be less effective or perform less than expectation. Specifically, the large cash balance may make managers to overlook the function of cost minimization in a company. Therefore, such companies may continuously report a growing balance of operating cost. An increase in the operating cost reduces the profitability of a company and earnings per share (Fresard, 2010).
Financing of share repurchase
The success of Apple, Inc. over the years is attributed to innovation and the introduction of high quality products in the market. The company has experienced organic growth since its formation. The table presented below gives information on the financial performance of the company over the past five years.
Source of data – United States Securities and Exchange Commission, 2013.
In the table above, it can be observed there was growth in the various balances reported by the company. Revenue grew by 298.35% while net income grew by 349.75% between 2009 and 2013. Total cash rose from $23,464 million in 2009 to $40,546 million in 2013. The increase is equivalent to 72.8%. The total cash balance is made up of cash held by the company and liquid investments. Thus, it can be noted that the company has a large cash balance in the books of account. A similar large cash balance is observed in other companies that operate in the same industry such as Cisco Systems and Google, Inc. among others. The Board of Directors of Apple, Inc. approved the share repurchase programs. In 2012, a repurchase of a maximum of $10 billion common shares was authorized. However, in April 2013, the board increased the limit to $60 billion. As at the end of the financial year for 2013, $23 billion of the allocation had been used. The program is expected to end in December 2015. In the program, the company uses open market and accelerated share repurchases.
A company can repurchase its stock using either cash reserves or proceeds from issue of debt instruments such as bonds, or both (Brigham & Houston, 2009). For instance, Apple, Inc. is using both debt and equity to finance the stock repurchase. A review of the financial statement shows the company did not have long term debt balances between 2009 and 2012. The company issued debt instruments in 2013 to finance the stock repurchase. The company intends to raise a total of $50 billion through debt to finance the repurchase. A similar trend is observed with other companies in the United States. The use of debt to finance repurchase has a number of advantages and disadvantages. Generally, stock repurchase gives an indication that a business entity is experiencing problems. Some of these problems can be caused by environmental factors, competition, deteriorating return on equity, or operating challenges. Thus, use of debt to finance repurchase is considered to be an aggressive way of executing financial restructuring in a company (Clarke, 2012). Thus, use of debt to finance repurchase for companies that are experiencing problems may worsen the situation. Currently, the price of debt in the United States is quite low. Thus, companies such as Apple, Inc. would prefer to use debt other than cash to finance purchase because it appears to be cheaper due to lower interest expense. However, the use of debt often lowers the credit rating of such companies. Analysts argue that the use of debt is sensible if it does not lower the current debt rating and if it results in capital optimization. Further, they are of the opinion that the use of debt is attractive if the resulting after tax basis is cheaper than the dividend yield. Thus, a company needs to evaluate the cost implication and the credit rating before using debt to finance the repurchase (Chan, Ikenberry, Lee & Wang, 2010).
On the other hand, the use of cash to finance repurchase is ideal because the essence of stock repurchase is to return to the shareholders the excess cash in the books of account. Thus, it is often viewed as a substitute for paying dividends. The use of cash is often considered cheap because it reduces the taxes. Secondly, it eliminates the interest expense. Also, it does not interfere with the credit rating of a company. Finally, it does not increase the leverage level of a company. However, the main drawback of using cash is that it may interfere with the liquidity of the company (Lins, Servaes & Tufano, 2010). Apple, Inc. should use the proceeds of a bond issue to finance the repurchase of shares because it will not significantly interfere with its credit rating. Besides, it will result in capital optimization because the company did not have debt in its capital structure between 2009 and 2012. Further, the market interest rate is quite low at the moment. Thus, the cost of debt will be lower. Finally, the use of debt to finance repurchase may allow the company to invest the “too much cash balances in viable investment opportunities.
References
Brigham, E., & Houston, J. (2009). Fundamentals of financial management. USA: Cengage Learning.
Chan, K., Ikenberry, L., Lee, I., & Wang, Y. (2010). Share repurchases as a potential tool to mislead investors. Journal of Corporate Finance, 16(1), 137-158.
Clarke, E. (2012). Accounting: An introduction to principles and practice. USA: Cengage Learning.
Collier, P. (2009). Accounting for managers. London: John Wiley & Sons Ltd.
Fresard, L. (2010). Financial strength and product market behavior: The real effect of corporate cash holdings. Journal of Finance, 65(1), 1097-1122.
Grullon, G., & Michaely, R. (2004). The information content of share repurchase programs. Journal of Finance, 59(1), 651-680.
Jensen, C. (1986). Agency costs of free cash flow, corporate finance and takeovers. American Economic Review, 86(2), 323-329.
Lee, S., & Suh, J. (2011). Cash holdings and share repurchases: International evidence. Journal of Corporate Finance, 17(3), 1306-1329.
Lins, V., Servaes, H., & Tufano, P. (2010). What drives corporate liquidity? An international survey of cash holdings and lines of credit. Journal of Financial Economics, 98(2), 160-176.
United States Securities and Exchange Commission. (2013). Apple Inc. form 10k (annual report). Web.