© 2000 John Petroff

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F- Analysis of cash and cash equivalents

Firms hold cash for numerous reasons: transaction needs (i.e. make regular payments), precautionary reasons (i.e. to deal with unexpected problems), speculative goals (i.e. to earn as high a return as reasonable on idle assets and from potential opportunities), future expansion of expense and assets, and requirements of lending bank to maintain a compensating balance.

1)- Optimum cash balance

In the beginning of this century, bank account arrangements (e.g. money market accounts, zero balance accounts) allow firms to leave practically no money idle without earning some interest. Only cash held as petty cash, or temporarily present in cash registers, earns no interest, and for most firms, especially manufacturing firms, this is practically negligible. Yet the return that can be earned from money market accounts is very low: 4.5% to 5.5% in 2000 when inflation is at 2%. Most cash that firms decide to hold is usually placed in marketable securities that can earn twice as much as money market accounts. For non-financial corporations, even the return on marketable securities is insufficient to justify holding them because the corporate average cost of capital is much higher (see Chapter 11 Section D-1), possibly approaching the return on equity which was on average 20% in 1999 (see Chapter 13 Section D-5). This means that there is opportunity cost of holding cash even in the form of marketable securities. This opportunity cost is increasing with the proportion of cash held: the fewer are the projects undertaken the higher their return.

But there is also a cost of not having enough cash on hand. This cost can be extremely high if very little cash is held. Indeed, the lack of cash on hand can prevent prompt intervention in catastrophes. And/or opportunities will be missed for lack of cash. As the cash balance increases, the cost of insufficient cash on hand diminishes, and becomes asymptotic to the cost of obtaining an advance from a line of credit (which is very little). Mathematically, the optimum level of cash is at the minimum of the combined cost of holding and being short of cash.

This minimum is entirely dependent on management's perception of the future, especially future expansion needs, potential for unexpected opportunities and major operations disruptions. It is also affected by company's ability to raise or borrow new funds. Both of these considerations are difficult to quantify. Moreover, daily payments are continuous, but major outlays for new projects are not. For these large payments, cash must be accumulated over months or years. Thus, cash management has two parts. One part is dealing with flows of regular collections and disbursements that requires an absolute minimum balance to be available year round (possibly larger in high paying season); this is best dealt with a cash budget described in the last section of this chapter.

The second part involves the accumulation of cash for long term needs and unforeseen catastrophes. This portion is much less mathematical. It is likely that identifying and evaluating underlying reasons (e.g. plans to develop new product) is far more important than the amount of cash a company decides to show on the balance sheet. Yet, if one reads that the company plans a major advertising campaign next year, the strategy would appear much more robust if the company has already set aside a substantial cash balance for that purpose. This analysis goes beyond liquidity and short term considerations. The safety a company builds up in such cash balance is best studied with the concept of free cash outlined in Chapter 10 Section F-3, and briefly touched upon in Section J-3 of this chapter .

See review questions Q-8F.1 through Q-8F1.8.

2)- Comparison between industries and companies

It is generally proposed that firms in manufacturing hold larger cash balances than firms in services or utilities, because they face more unstable markets. Table T-8.6 presents average proportions of cash in total assets of 80,000 American firms grouped in eight sectors and by size of sales in 1999.

Based on empirical data studied in 1999 and presented in Table T-8.6, the general belief that manufacturing firms hold a larger proportion of cash is not confirmed. Manufacturing industries hold on average 7% of assets in cash, compared to of 12% for services and information sectors for example. Moreover, the larger cash holding of service companies is not attributable to a larger proportion of smaller firms in services than in manufacturing: larger proportions of cash of service companies is observed in every company size group.

The other general belief is that smaller firms should have larger cash balances because smaller firms have a more difficult access to capital markets and borrowing, and because their need to grow is more urgent than that of large firms. The 1999 data presented in Table T-8.6 generally supports this belief, but not for all industries. While the recommendation seems most wise, the 1999 empirical data shows that smallest firms in manufacturing and transportation do not have larger proportions of assets in cash than larger firms. This is all the more disturbing because small firms in manufacturing tend to face a more unstable and uncontrollable business environment. The empirical data may be showing that a large proportion of smaller firms in manufacturing are in financial difficulty (as it will be confirmed in Chapter 11 Section E-2 and Chapter 13 Section D-4 when net worth and profitability are studied). That leads us to two obvious but important observations for the manufacturing sector in the United States in 1999: a)- firms that are healthier will have larger cash balances, and b)-there are more of those among larger firms.

See review questions Q-8F2.1 through Q-8F2.3.

3)- Historical comparison

Table T-8.7 below presents the break down of assets held by corporations in the United States for selected years over the past 40 years. This data is highly aggregated and not entirely comparable to numbers used elsewhere in this chapter (which look at eight sectors only).

The data clearly shows a significant decrease in the proportion of cash on hand. One can speculate on many different reasons (some of which have previously been mentioned) that can explain the increasing proportion of fixed assets and the decreasing proportion of liquid assets: greater financial intermediation, easier access to capital and financial markets, greater availability of insurance, more stable economy, and more sophisticated money and financial assets management.

See review questions Q-8F3.1 and Q-8F3.2.

4)- Cash ratio

A ratio rarely used except in analysis of companies in difficulty or with highly speculative investments is known as cash ratio. The cash ratio is calculated by

Cash Ratio = Cash + Marketable Securities / Current Liabilities

As an example of calculation of this ratio, we can take data from Merck Balance Sheet . Cash and cash equivalents amount to $3,356 millions and current liabilities to $ 6,069 millions. This give a cash ratio for Merck in 1999 of Cash ratio = 3,356 / 6,069 = 0.55 This is an exceptionally high value for the cash ratio, as can be verified by calculating cash ratios of the other firms used as examples in this text for Timken Balance Sheets , Lucent Technology Balance Sheet, Delta Air Lines Balance Sheet , Bell Atlantic Corporation Balance Sheet , and AO Boom GAAP Balance Sheet . In following chapters, reasons for Merck's large cash balance will be explored in several examples.

See review question Q-8F4.1.

See research assignments R-8F.1 through R-8F.5.

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