Back May 31, 2016

Excess Cash. When Much Becomes Too Much

We talked about how running out of cash is bad for your business. To avoid this stressful situation, you may expect that building a solid cash reserve is the right thing. Well, yes and no. Yes — having some cash reserve will save you a lot of trouble, but too much can prove too much. Excess cash is just as unhealthy as no cash at all (all right, maybe a little less). Let’s see how.

First of all, when do we talk about excess cash? It refers to that situation when your cash exceeds the normal amount needed by your business to function well (including a safety reserve). General guidelines consider that cash is in excess when it represents more than 20 % of the revenue. This is when it becomes cost-inefficient to have money that is not used for the business.

Excess cash can lower the Return On Assets

We know that management efficiency translates into generating more revenue with less investment. So if we consider cash reserves as part of the company’s assets, the more cash it has, the higher the investment. By increasing the base to which we refer, the result will be lower — a lower ROA. Let’s take an example. Let’s say that your assets have a total value of 10 million dollars and your revenue is 1 million dollars. Then your return on investment is 10 %. If you add to your assets extra cash reserve of 5 million and the revenue stays 1 million (as you didn’t invest the cash to increase operations and earn more money) the ROA becomes approximately 6.7 %, which is lower than the “no extra cash reserve” situation.

More cash means more Cost of Capital

Having too much cash that is not used to support the company’s activity means more costs for keeping that reserve. Take into account that these extra costs add up to the decrease of ROA; it happens at the same time: excess cash costs money and it brings down the efficiency of the company’s assets. In other words, the company is losing money (it pays more than it earns from the assets it has). On paper, it may seem that a lot of money in the bank account means you are doing well. Be aware, though; strategically and from the business health point of view, an increase in the Cost of Capital combined with a decrease of the Return on Assets brings dark clouds on the horizon.

Managers might relax too much

Is there such thing as too much relaxation? When it’s about business, yes. Having high cash reserves can lead managers to loosen their control over the revenue streams and the cash flow. On short term there is no danger, but on the long run — yes. Having no pressure from the revenue point of view leads to lowering the managers’ vigilance. This equals fewer opportunities seized, less innovation, lower or no growth, not keeping the pace with the competition and changes in the market. Being too comfortable with the current situation implies low or no evolution.

These being said, be aware of the mermaid song of excess cash. As charming as it may seem to have a solid safety net for times of struggle, don’t lose balance. Keep an eye on the cash flow and when more cash becomes too much, think of making that money work for the business, not against it.

Photo credits to Hoach Le Dinh