Skip to main content

How can a Company use Excess Cash Balances efficiently?



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).
Labels:

Comments

Post a Comment

Popular posts from this blog

What are the Crosby’s 14 Steps Work.

The 14 Steps of Crosby are following. 1. Management Commitment= It is necessary to consistently produce quality products and services at the optimum price. This commitment must also be transparent to all employees for the prevention of defects in all the operating departments. 2. Improved Quality= Search for team members who will model quality improvement commitment, every function of an operation must contributes to defect levels, every function must participate in the quality improvement effort . The quality improvement team should be able to effectively commit themselves to improvement of quality. 3. Measuring the Quality= Firstly you have to know exactly where your products and services lie when it comes to conforming to requirements. Thus, the third step on Crosby's list is to measure quality. Determine where there is room for improvement and where potential for improvement exists. 4. Cost of Quality= Explain how the cost of quality figures into the overal...
1 comment
Read more

Discuss national income and Gross domestic product effect on national income.

Discuss national income and Gross domestic product effect on national income. Before we start to explain let’s take a look on closed and open economy In a closed economy, all output is sold domestically, and expenditure is divided into three components: consumption, investment, and government purchases. Y = C + I + G In this equation Y is the total output, C is the total consumption, I is the total investment and G is the total government expenditure. In an open economy, some output is sold domestically and some are exported abroad.                                                                   Y = C + I + G + NX In the above equation each word stands for is following: Consumption (C) Investment (I) Government Purchases (G) Net Exports (NX) Consumption : The spending by households on goods and services, with the exc...
Post a Comment
Read more

Define Parametric and Non parametric test. When these tests are used? Also define their sub types along with examples

Explanation: Parametric tests = It is the Procedure of hypothesis which explains that the variables of interest are measured on at least an interval scale. It is parameters defining properties of the population distribution from which one's data are drawn, Uses of Parametric Tests 1: uses in skewed and non-normal distributions=Parametric tests can be used with continuous data that are non-normal if you satisfy these sample size guidelines. For example sample t test (each group should be greater than 15) and in ANOVA (if you have 10 -12 groups then each group should be greater than 20). 2: uses for when spread of each group is different= For nonparametric tests data for all groups must have the same spread (dispersion). If your groups have a different spread, the nonparametric tests might not provide valid results. In parametric tests you’re good to go even when the groups have different spreads. 3: uses as a Power=Parametric tests usually have more statistical power tha...
Post a Comment
Read more