Use of Excess Cash ,its Effects, and Consequences=
We can use excess cash balance efficiently by keeping in mind the following points: Excess cash balance has three disadvantages from which we can plan how to use excess cash balance efficiently by converting disadvantages into advantages :
1. Excess cash can lowers your ROA (return on Assets)
2. Excess cash can increases your COC (cost of capital)
3. Excess cash can increases overall risk by overly confident management team
Return on Assets =
When your cash balance exceeds your actual working capital cash balance need, you have excess cash, or cash that is not necessary to the firm’s financial operations. For this example, we’ll use a business with total assets of 1,000,000 and cash making up 10%, or $100,000, of that total. Let’s say this business has an annual after tax net income of $100,000, which equates to an overall ROA of 10% ($100,000 / $1,000,000). If the business is only earning 2% annual interest on the cash portion of the total assets, then the real effect of cash can be determined.
Cost of capital =
The second effect of excess cash occurs simultaneously in the scenario above: excess cash increases your Cost of capital, Using the example company above, lets assume the weighted COC is 10%, a common percentage for mid-size, privately held companies. With a COC of 10% and a ROA of 10%, this company is losing money on invested capital! It would be like selling your products at less than what it costs to make them. No one would purposefully do that. Lowering the cash portion , lowers the most expensive portion of COC.
Overall risk =
Management team becomes over confident and use excess cash more than its budget which results in overall risk of the company and increase the chances of loss for the company.
When the COC consistently exceeds the ROA, the overall risk of the business goes up This situation results in a constant destruction of capital and increased risk by restricting the company’s access to capital. It also lowers its market value relative to book assets and book equity while increasing its real debt burden (if the company is financed).
When your cash balance exceeds your actual working capital cash balance need, you have excess cash, or cash that is not necessary to the firm’s financial operations. For this example, we’ll use a business with total assets of 1,000,000 and cash making up 10%, or $100,000, of that total. Let’s say this business has an annual after tax net income of $100,000, which equates to an overall ROA of 10% ($100,000 / $1,000,000). If the business is only earning 2% annual interest on the cash portion of the total assets, then the real effect of cash can be determined.
Cost of capital =
The second effect of excess cash occurs simultaneously in the scenario above: excess cash increases your Cost of capital, Using the example company above, lets assume the weighted COC is 10%, a common percentage for mid-size, privately held companies. With a COC of 10% and a ROA of 10%, this company is losing money on invested capital! It would be like selling your products at less than what it costs to make them. No one would purposefully do that. Lowering the cash portion , lowers the most expensive portion of COC.
Overall risk =
Management team becomes over confident and use excess cash more than its budget which results in overall risk of the company and increase the chances of loss for the company.
When the COC consistently exceeds the ROA, the overall risk of the business goes up This situation results in a constant destruction of capital and increased risk by restricting the company’s access to capital. It also lowers its market value relative to book assets and book equity while increasing its real debt burden (if the company is financed).
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