Cash rich companies are boon or curse?

Tue, 8 May Pre-Open

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A healthy cash balance (net of debt) and strong cash flows are favorable indicator to company's performance. Unlike other line items that can be manipulated, cash balance and cash flows reflect the real picture. However, it will be a folly to value company on this basis. Simply because it ignores the present value of future inflows. The key point is how a company uses its cash. Does the company reinvest it back into business to generate higher returns, or returns it back to shareholders for lack of investment opportunities or just chooses to sit over it? Understanding how the cash would be used is important before making an investment decision.

The decision to reinvest or not depends on whether the investment opportunity offers returns better than what cash at bank does. In the times of volatility and economic uncertainty, the importance of having cash in hand can't be undermined. Still from an investor's point of view, cash that does not go into buying assets and enhancing returns over a period of time becomes value dilutive for shareholders. This is because interest earned on the cash is lower than cost of equity. Hence, the best course of action in this case is to return the cash to investors in the form of dividends or share repurchase.

However, a look at cash balance of some of the top Indian companies will make it clear that the real situation is far from this. Companies like Reliance Industries, Infosys and Oil India are sitting on cash worth 19.5%, 61% and 135% respectively of the company revenues in FY12. While Reliance has taken baby steps in redistributing cash by announcing a buyback worth 14% of cash on books, Infosys is still counting on better investment opportunities to come its way.

And it's not just in India. Cash conservativeness has become a global trend. Well, this may seem to be a sensible approach for the management in the midst of global uncertainties. However, the choice one has to make is not between holding cash and making a risky investment. Instead it is holding cash versus rewarding shareholders directly for the lack of better ways to do so. This is especially true for public sector companies. The surplus cash with the latter is eyed by the Government to plug its fiscal gap, even at the cost of wealth destruction of the companies.

To conclude, as an investor, one must understand how the management plans to use its cash. High cash is not an issue for a company that earns strong return on equity by investing it into the business. But in case of a company that has a track record of making bad investments; cash is safer in the hands of its investors.