Companies with too much Cash: Good Stock Buy?

Management has Alternatives to Deal with Extra Cash

What does it mean when a company you are following or own stock in is awash in cash?

What if its balance sheet is overflowing with cash? The company is sitting on a big pile of money.

This is a good thing, right? Wrong.

While having a sufficient cash to fund ongoing operations and cover any short or long-term debt is necessary for a health company, too much cash may not be in the stockholders’ best interest.

Mature Stocks

You often find mature companies in this situation (think Microsoft, GE, also utilities) because they have built a large customer base and dominate a market(s).

Rolling out new products almost guarantees a flood of cash.

The test of whether management has the stockholders’ best interest in mind is revealed in what the company does with the extra cash.

Alternatives

What the company does depends on several factors, including its long-range plan, however in general, here are the main alternatives:

• Acquisition – The company can use the cash to acquire another company to expand its reach in the market or to enter a new market. Although acquisitions can increase shareholder value, not all work out the way management plan.
• Dividend – The company can payout some of the cash in dividends to the stockholders. This reflects an understanding that the owners deserve to benefit from the company’s profits.
• Buy back shares – The company can buy back its own shares, which has the effect of increasing the value of the remaining outstanding shares. This benefits existing shareholders and is a non-taxable event until shares are sold.
• Investments/Debt reduction – The company can invest cash if returns are attractive and/or pay down debt if that is the best use of the cash, which increases shareholder.

Ultimately, management’s decision on how to use excess cash should be driven by what is in the best interest of shareholders.

Acquisitions

Of all the alternatives listed above, the riskiest is acquisition, since that involves making another business relationship work.

Many companies with large amounts of cash will use more than one of the alternatives listed above.

Sitting on a large amount of cash with no strategic reason is not in the best interest of stockholders.

You may want to consider this when evaluating a company before purchasing its stock.