Why Are Companies Hoarding Cash ?

Traditional finance does not propagate excessive holding of cash. The question of how much cash should a firm have on hand has been widely discussed and debated. The conclusion was that each firm has its own appropriate level of cash that should be kept on hand.

Ratios such as current ratio and quick ratio were developed to find out this appropriate level. The rule of thumb was that firms should keep enough on hand to meet interest payments, wage payments and any other near term cash requirements that the firms may have.

The idea was that any excess cash should immediately be invested to earn interest. Too much cash on the balance sheet was viewed negatively. It was considered that the company’s management does not have any vision. Otherwise, they would not leave the cash lying around idle.

It was believed that holding large amounts of cash leads to opportunity loss. It could cost the company dearly if the competitors used the money to build up large competitive moats.

New age tech companies have defied this thinking. Several companies are sitting on massive stock piles of cash. Apple Inc, the world’s most valuable company, is sitting on over $250 billion in cash surplus. Warren Buffet’s Berkshire Hathaway also has over $100 billion in cash reserves. Such huge cash reserves that were unheard of are now the new normal. This trend has changed after the 2008 crisis began. Firms all over the world have started hoarding cash instead of investing them in securities.

In this article, we will understand some of the common reasons behind this phenomenon.

Why Do Businesses Hoard Cash?

The changes in the external environment are responsible for the change in the way businesses are behaving.

• Precautionary Motive: Cash crunch was one of the reasons why several businesses collapsed during the 2008 crisis. The businesses seem to have learned their lesson. They now know that not having enough cash on hand makes them a slave to the whims and fancies of investors who may not be well capitalized at all times.

  Hence, companies have started holding more cash to stop being desperate and overly dependent on external funding if a crisis breaks out.

  Businesses have started correlating a higher cash reserve with better chances of navigating another economic downturn. It must be noted that mere precautionary motives do not justify the $250 billion dollars that companies like Apple are hoarding within its coffers.

• Lack of Opportunities: The 2008 slowdown has also led to the reversal of economic fortunes across the globe. Although there isn’t a recession, the economy isn’t growing too fast either. There is stagnation in the macro economy. As a result, companies do not feel the need to expand their capacity and manufacture more.

  Since the scale of operations does not have to be increased, there is less need for undertaking investments. In the absence of viable investment options, money remains within the company’s bank accounts. This accumulation of excess cash since 2009 has partially led to this situation wherein companies have excess cash.

• An Anticipation of Better Returns: Businesses are aware that interest rates move in cycles. After a period of low-interest rates, comes a period of sky high interest rates. This is an axiomatic truth. There is no question of whether this will happen. The only question is when the interest rates will rise.

  Firms want to be prepared for this high-interest rate Armageddon. They can then use the cash to avoid taking on expensive debt at a later date. They could also pay off the higher debt. Another option is to get a higher interest rate on the cash simply.

Alternate Uses of Cash

Whenever companies have excess cash, they end up doing one of the two things that have been mentioned below.

• Mergers And Acquisitions: M&A activity is fuelled by idle cash lying in the vaults. This is the reason why companies like Infosys are being forced to find acquisition targets. The idea is to keep the company growing even though the market is stagnant. Excess cash can be used to consolidate the industry in the hands of fewer players and reduce the competition. This usually provides more pricing power to the acquiring company in the long run.

• Share Buyback: Lastly, if the company has nothing to do with its money, it should give it back to the investors. This could be in the form of a bumper dividend offer. On the other hand, it could also be in the form of a share buyback. Buybacks restore investor confidence since they show that the company is willing to bet its own money on the fact that the stock price will go higher. Once again, this trend has been rampant in the Indian IT industry. Companies like TCS, Infosys, and Wipro have been forced by investors to buy back their own shares at a premium.

To sum it up, the rules of the cash game have changed. Holding up huge reserves of cash is the new norm. It needs to be seen whether this norm will sustain over a longer period of time or whether the world will move back towards the traditional conception of cash management.

Authorship/Referencing - About the Author(s)

The article is Written and Reviewed by Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.