Excess Cash

Excess cash is the pot of gold a company holds over and above what it needs to run its day-to-day business. Think of it as the money left in the company's wallet after paying all its bills, funding its operations (its `working capital`), and making necessary investments for the future (its `capital expenditures`). For a `value investing` enthusiast, spotting a company with a growing pile of excess cash is like finding a treasure map. It often signals a highly profitable business that gushes cash. However, it's a double-edged sword. While it provides a safety cushion and immense flexibility, a mountain of idle cash can also be a red flag, raising serious questions about management's ability to use that capital wisely—a concept known as `capital allocation`. It's not enough for a company to make money; it must also know what to do with it.

Excess cash tells a story about a company's health and its management's competence. It's a crucial piece of the puzzle when you're trying to determine a business's true worth.

A healthy pile of excess cash is a beautiful thing. It's a sign of a strong business, likely protected by a durable competitive advantage, or `moat`. This financial firepower gives a company incredible strategic options and a buffer against tough times. With this cash, a company can:

• Reward Shareholders: Pay or increase `dividends`, or repurchase its own stock through `share buybacks`, which can boost the value of the remaining shares.
• Fuel Growth: Fund strategic `acquisitions` to expand its market presence or acquire new technology without having to take on expensive `debt`.
• Weather Storms: Survive economic downturns or industry-specific slumps without having to panic-sell assets or dilute shareholders by issuing new stock at low prices.

On the flip side, a perpetually growing cash pile that just sits on the `balance sheet` can be a sign of a lazy or uninspired management team. Money that isn't working is losing value to `inflation`. This phenomenon is often called a `cash drag` because the low return on cash (often near zero) drags down the company's overall `return on equity`. Shareholders don't invest in a company for it to act like a low-yield savings account. An enormous, untapped cash balance can also make a company a tempting target for activist investors or corporate raiders who believe they can deploy that capital more effectively.

Figuring out the exact amount of excess cash is more art than science, but you can get a pretty good idea with some simple detective work.

A quick and dirty way to estimate excess cash is to look at the “Cash and `Cash Equivalents`” line on the company's balance sheet. Then, try to determine how much of that is truly “excess.” A common benchmark is to assume that cash amounting to more than 5% of a company's annual `revenue` might be surplus. For example, if a company has $1 billion in revenue and $200 million in cash, you might estimate that $150 million of that ($200m - (5% x $1b)) is excess. Warning: This is a very rough guide and should be the start, not the end, of your analysis.

A more sophisticated approach acknowledges that different industries have different needs.

• Industry Matters: A capital-intensive business like a railroad or an automaker needs a lot more cash on hand for maintenance and investments than a software company with low overhead.
• Look for Changes: Compare the current cash level to the company's own history and to its direct competitors. Is the cash balance suddenly ballooning? If so, why?
• Listen to Management: The best source of information is the company itself. Read the `annual report` and listen to `earnings calls`. Management should be able to explain why they are holding so much cash. Are they saving up for a specific, large acquisition? Are they anticipating a downturn? A good management team will have a clear and rational plan.

Ultimately, excess cash is a test of management's character and skill. As an investor, your job is to judge how they are handling this test. Famed investor `Warren Buffett` has often criticized managers who use their cash hoards for foolish acquisitions, a process he humorously calls `diworsification`. When you find a company swimming in cash, ask yourself:

1. What is management's track record with capital allocation?
2. Are they returning cash to owners through intelligent share buybacks (i.e., when the stock is undervalued) and sustainable dividends?
3. Are their acquisitions strategic and value-accretive, or are they just empire-building?

Finding a business that generates tons of excess cash is the first step. The real home run is finding one run by managers who know how to use that cash to relentlessly increase long-term `shareholder value`.