There have been on-going debates as to whether or not; firms and corporations should hold excess cash on their balance sheets or distribute them to their shareholders…
Looking at the pros and cons in terms of shareholder wealth maximization among others, many have urged that holding excess funds is of great benefit to both the firm and its investors, whereas others believe that holding excess is simply holding on to a negative debt. This they argue does not result in increase in earning per shares but only result to loss of funds due to currency floatation.
There are a number of factors that cannot be overlooked by larger corporations when it comes to excess cash.
First of all, corporations hold excess cash in order to allow them spot future opportunities take advantage of these opportunities with the backing of the availability of cash reserves and make future investment without needing to add debt to capital structure.
According to the investor’s Business Daily, American multinational conglomerate; Alphabet Inc. holds a cash reserve of $103.7 billion, while tech giant Apple Inc. also holds a net cash of $90 billion as at the year 2020. Other large corporation like Facebook, Microsoft, Cisco systems, Nvidia and Paypay has been reported to hold huge net cash.
The obvious reason these multinational corporations keep this huge excess cash is to allow them invest in new opportunities such as buying newer firms which might potentially be a threat to their level of profitability in the future.
Facebook in 2012 bought Instagram, with an employee strength of 13 people, for a shocking sum of $ 1 billion, though it was a shocking amount to pay as at 2012, of which many spoke against.
However, Facebook saw Instagram as a potential threat, thus the takeover. Instagram as at 2021 has over 1 billion users and contributes over $20 billion of Meta’s annual revenue.
This obviously increases shareholder wealth. If Facebook now Meta group in 2012 distributed its cash in hand and failed to hold excess cash in anticipation of an opportunity, it would have simply walked away from making this profitable investment and thereby losing the opportunity to eliminate the threat of Instagram.
Though one might argue that excess cash is a negative debt, in the case of unidentified industries, which I agree to be true such that corporations need not hold cash but should use debt to finance new opportunities or issue equity in order to raise capital to finance profitable ventures. This is because, by adding debt in a recapitalization, a company is likely to increase its market value which further increases the company’s earning per shares as well as benefits from tax shields.
When corporations fail to hold excess cash which eventually become essential cash, in an event that the corporations seeks to undertake a new investment, it will have to add more debt to its capital structure to enable it finance such projects.
Building up lots of debt only does one thing to a corporation, which is increasing the chances that the firm runs into situations where it has no sufficient cash to pay its obligation thereby becoming a financially distressful company.
An instance is the case of the collapse of 178 years Aircraft Company Thomas Cook. Thomas Cook, racked up a debt stock of $1.7 billion after it begun a $750 million recapitalization, which later became $900 million, then $1.1 billion.
Though, a company might not have to pay taxes on interest payments, and increase its market value, when it picks up debts, building up more debt as stated opens the door to a firm becoming financially distressed, which results in corporations losing cash flows, in legal expenses payments, courts and advisory fees, liquidation of assets through fire sales.
A company in this position will lose some of its talented employees, loss of customers, and suppliers refusing to deal with the business or supply on account.
Competitors may also take advantage of this situation and launch a price war, further worsening the ability of the firm to become profitable.
It is therefore wise that the Company should hold excess cash in anticipation of a new opportunity.
The second reason corporation should hold to excess cash is because as trade- off theory postulates, a firm optimal cash holdings is usually determine by a balance between the cost and benefit of holding excess cash especially in situation where cash flows are uncertain.
According to the Harvard Business Review , Non U.S financial corporations hold just over $4 trillion dollars in cash and according to the latest flow of funds estimates, corporations held up to $2.7 trillion dollars in cash in 2010.
Holding excess cash provides good buffer during times of uncertainty or risk of financial markets. This offers protection to the firm against adverse cash shocks.
Therefore, holding excess cash will offer the firm the ability to finance critical projects.
Also it is important for companies to hold excess cash rather than distribute them to shareholders, to avoid paying huge taxes.
In 2013 Apple in its efforts to avoid paying huge taxes, held over 90 % of its $252 billion profits in cash, because this profit is subject to corporate income tax as soon as it is repatriated back to the U.S. Apple by holding this profit in cash according to the institute on taxation and economic policy avoided paying $78.6 billion in taxes.
This academic article was authored by Ananpansah Samuel, a tutor at the Accra Business School.
By Ananpansah Samuel
(Accra Business School)