Stock markets: Investing in a cash-rich firm? Check the source of cash

As an investor, you should know why a firm’s cash pile has goes up. Look at the cash flow statement and not the balance sheet to know the source of such funds.

Stock markets: Investing in a cash-rich firm? Check the source of cash
Stock markets: Investing in a cash-rich firm? Check the source of cash

Though cash is king, managing cash and identifying an optimal cash balance is a critical job for most of the managers. Poor cash management can negatively affect a company’s performance and at the same time, having too much cash can also affect the business. But, the general perception in the minds of the investors is to invest in cash-rich companies. Let us understand the meaning of ‘cash rich’ and whether it is a good idea to invest in such companies.

Meaning of cash rich

Generally, cash and cash equivalents are the important indicators of the company’s financial soundness and well-being. Cash rich or excess cash means a scenario where a company has cash and cash equivalent in excess of working capital. Firms normally keep some excess cash for future requirements or to respond to adverse risks. Cash provides various options to a firm.

For instance, firms with a large amount of cash can invest in research and development, acquire another company, embrace new technologies faster than its peers and probably increase dividends or repurchase stock. Therefore, many investors prefer to invest in companies with large and growing cash piles on their balance sheets. This investment philosophy is theoretically great, but it is not always a better idea.

Source of cash

As an investor, you should know the reasons why a firm’s cash pile has gone up. There are different ways through which a company can boost its cash pile. One simple way is to take debt. Increasing cash balance by taking a debt creates debt interest obligation. Another way to increase cash is via sale of assets. These activities will increase the cash balance in the balance sheet.

In order to know the source of cash, investors should look at the cash flow statement and not the balance sheet. In the cash flow statement, if cash from operations are positive consistently over a period of time, it is a good signal. At the same time, if the company’s outflow in investment activities are not going up consistently, one needs to identify the reasons for the same.

Issues with excess cash

Firms amass cash for a variety of reasons. Often, excess cash may be invested skilfully in a business in which the company has no core competency and it is going for an inorganic expansion. There are evidences in the developed and developing countries that excess cash is wasted by firms in buying private jets, private islands, investing in non-core business activities, etc.

Even in India, there have been a number of instances where cash-rich companies have indulged in wasteful expenditures and over-valued acquisitions. It is obvious for investors to assume that cash-rich companies are great buys, especially when economic revival is on because companies with excess cash are likely to be the ones to invest and grow aggressively. So investors don’t mind paying a premium to buy such stocks. However, it is very essential to know the capital allocation skills of the management of these companies before investing.

To conclude, having excess cash is the outcome of past success, not future capability. So, consider the above factors while looking to invest in cash-rich companies.

The writer is professor of finance & accounting, IIM Tiruchirappalli

Get live Share Market updates and latest India News and business news on Financial Express. Download Financial Express App for latest business news.