Imagine if you have S$100m in your bank account, what joys and problems would you face? I believe some of the joys would entail sacking your boss, living it extravagantly but problems would include the deployment of cash, as well as, fearing for your life if people are aware of your immense wealth.

If the above situation happens to companies with large cash holdings, the management would also face similar problems, especially on the issue of effective cash deployment. So for companies with a large cash hoard, is it a boon or a bane? Let’s delve into the pros and cons of maintaining a substantial cash hoard.

Advantages

Reflective of a company with strong business performance

One of the advantages is that a large cash hoard signals that the company seems to accumulate cash faster than it can deploy (assuming that the company is effectively deploying its cash but it is still accumulating).

Furthermore, it is also reflective of a good business performance as cash is derived from profitable operations.

Buffer against bad times

Cash can be used as a buffer against bad times or mistimed acquisitions. For example, during the recession in 2008/09, companies with large amounts of debt and little cash face refinancing difficulties and some even have problems paying off the loans when they are due. Ferrochina, ex Singapore listed firm in the manufacturing sector, is a case in point.

Moreover, cash serves as a safety net against unpredictable events. Companies which carry out acquisitions, joint ventures, or maiden expansions into new markets or geographies are likely to face their fair share of failures and difficulties. Some business ventures may not reach their desired results and may run into temporary losses. Cash can be used to cover the losses in such situations.

Business facilitator

Companies with cash holdings are also likely to be able to get favourable credit terms with suppliers and banks. This is apparent as suppliers and banks have to access the credit risk of the companies which they are doing business with and companies with a considerable amount of cash holdings would allay part of their credit concerns. This would aid in the business operations of the companies.

Flexibility for future growth

Cash also provides management with a myriad of options for future growth. For example, management can decide on the following options

• Look out for attractive acquisition targets either to expand horizontally or vertically along the value chain.

• Carry out capital expenditure such as to acquire land for future purpose, or expand their production capacity through buying more machines etc.

• Invest in listed companies purely for investment purposes.

Disadvantages

Dearth of attractive investment opportunities

One of the most obvious reasons for a large cash hoard is that management has exhausted attractive investment opportunities at the moment and is keeping cash for future opportunities whenever that may be. This does not benefit shareholders as holding substantial cash incurs an opportunity cost and also drag down the return generated by the companies. Besides, shareholders prefer companies to return cash or carry out share buybacks if there are no attractive investment opportunities by the companies.

Lack of long term planning

Some companies may not have the practice of planning for the long term. Thus, as they do not have a concrete idea of their cash requirements over the next three to five years, they would prefer to hold cash as this provide them with flexibility. Nonetheless, it is generally non ideal to invest in companies which do not execute long term planning, as “failure to plan means planning to fail”.

Agency costs

With substantial cash in the companies’ coffers, management may be tempted to use these funds to build their own empire by spending on non synergistic acquisitions and loss making projects, so as to boost their power, reputation and prestige.

Possibility of incurring suspicion and indignation from shareholders

If the cash hoard is increasing and management does not have concrete plans on the use of such funds, this may incur the suspicion on the authenticity of actual cash owned by the companies. For example, Oriental Century, a Singapore listed firm in the education sector, has a large amount of cash in its books. However, it is subsequently revealed that its Chief Executive Officer has allegedly inflated the cash holdings.

Another company, China Hongxing, a Singapore listed firm in the sports shoe and apparel sector, has been incurring the indignation of shareholders for more than a year by sitting on a large cash hoard, amounting to RMB3b at Dec 09, up from RMB1.9b at Dec 08. The collapse in its share price from the high of S$1.45 in Oct 07 to a low of S$0.055 in Mar 09 was due in part to investors’ angst and displeasure in China Hongxing management of cash. However, China Hongxing management has recently unveiled plans on how it would be deploying its cash.

Conclusion – evaluate against the overall context

To determine whether having a large cash hoard is beneficial to shareholders, shareholders have to evaluate against the following criteria:

• Companies’ existing and future incoming cash flows;

• Companies existing and future cash flow requirements (i.e. outflows);

• Stage of business cycles;

• Existing loan and interest repayments.

Thus, if the companies have concise plans to deploy their cash, either to satisfy outstanding loan repayments, or for synergistic acquisition purposes, or for capital expenditure in view of the recovery in the business cycles, then the cash hoard is a boon as it creates shareholder value.

Conversely, if management has no concrete plans to deploy the cash or to deploy them in reckless fashion, then, the cash hoard is a bane as it destroys shareholder value.

Once again, investors have to put on their thinking hats and do some work to reach a decision on whether the cash hoard is a boon or a bane for shareholders.