Finance scholars have long urged corporate managers to hold less cash and assume more debt. Too much cash, the argument went, could make executives lax, encouraging imprudent acquisitions and spendthrift expansions. Debt, in contrast, brought discipline: you don't do dumb deals when you know you have to make regular interest payments. Rather than stockpiling cash, these thinkers argued, companies ought to be paying dividends.
Managers, it appears, haven't been listening.
At least that's what research by Thomas Bates, a W. P. Carey finance professor, suggests. In a paper recently published in The Journal of Finance, Bates and his co-authors -- Kathleen Kahle of the University of Georgia and Rene Stulz of Ohio State University -- find that, as of 2004, major U.S. corporations held so much cash that they, in effect, had no debt. Put differently, their net debt -- debt minus cash, divided by book assets -- went negative in 2004 and stayed there 2005 and 2006.
"Another way to see this evolution is that the average [cash-to-assets] ratio more than doubles over our sample period, from 10.5 percent in 1980 to 23.2 percent in 2006," the scholars write.
Freedom from accountability?
Other researchers have noted this trend and offered all sorts of explanations for it. One popular theory says that entrenched managers have socked away cash because it serves in their selfish interests to do so. Lots of cash gives them freedom to do what they want, shareholders be damned. Debt, in contrast, requires answering to investors and banks.
Back in the mid-2000s, the cash troves of some firms seemed to bear out this argument. Outfits like Microsoft and Exxon Mobil were so rich with cash that they became the subject of critical stories in the popular press. Story after story suggested that they and others companies like them were hoarding funds, rather than investing in future growth. In 2004, The Wall Street Journal wrote that Microsoft "faces increasingly impatient calls by some investors to share some of [its] stockpile of nearly $60 billion in cash and short-term investments." That same year, the software maker decided to give its shareholders a one-time dividend of $32 billion.
Some scholars have argued that the huge slugs of cash on the balance sheets of dominant firms like Microsoft and Exxon Mobil caused the "cash glut." According to this line of thinking, these firms' holdings were so big that they skewed the averages.
Bates and his co-authors sort through this and various other theories for why firms are holding more cash and find them wanting. For example, they show that companies with entrenched managers did not have the biggest cash holdings. Far from hoarding cash, these managers did just the opposite: "We find that the firms … in which managers are presumably most entrenched experience the smallest increase in cash holdings from 1990 through 2006."
The biggest companies' holdings didn't explain swelling cash reserves, either. Their holdings swelled over the study period, but so did the holdings of other companies of other sizes. In other words, cash on the books of Microsoft, Exxon Mobil and other behemoths didn't explain the trend.
What then might explain the growth of cash holdings? How about plain-old financial prudence? Bates, Kahle and Stulz argue that companies, in putting away cash, are responding sensibly to a changed world. Today's economy entails more risk. New competitors arrive daily from around the globe, and consumers have the ability to switch products with the click of a mouse. Extra cash offers a way to cushion against rising risk.
"We find that the average cash ratio increases by less than 50 percent for firms in the industries that experience the smallest increase in risk but by almost 300 percent for firms in the industries that experience the greatest increase in risk," the researchers write.
The riskiest firms, in other words, are holding the most cash.
"They're using their cash to hedge against rainy days," Bates explains. "A gold producer can hedge against future bad outcomes with gold futures. A company making iPods or software can't hedge as easily."
These risks stem partly from the changing nature of companies in the modern economy. Consider Apple. Compared with, say, a carmaker or an electric utility, a technology company like Apple has relatively few physical assets. It may even outsource the manufacture of its devices to other outfits, choosing to focus its energy and resources on R&D, product development and marketing. Its key assets are its people, not plants and equipment.
"An old-line industrial firm might shut down an assembly line when it runs into hard times," Bates points out. "But if you're a technology-based firm, you can't lay off half your workforce in the middle of an R&D project. Those people are programmers and engineers, and they won't be there if you try to start up again next year. They'll have gone to work for someone else." Holding more cash enables a company like Apple to keep paying its programmers and engineers when unexpected shocks arrive.
Owning fewer physical assets also means that companies have less collateral for loans. Often, when a traditional industrial company borrows money for a new piece of equipment, it pledges that equipment as collateral. In theory, if it fails to pay back the loan, the lender can take the collateral and sell it. But high-tech and service-based companies, which increasingly predominate in today's economy, tend to have fewer hard assets and thus less potential collateral. That's another reason that they hold cash. Their reserves protect them in times of financial need, making them less reliant on banks and other lenders.
What happened during the recession?
The period that Bates and his co-authors study for their research ended just a couple of years before the recent financial crisis. But the crisis is the sort of shock that they envision when they write about cash-flow volatility. During the crisis, bank financing dried up. Companies with insufficient cash found themselves struggling to survive. Even firms with cushions "were burning through the cash that they had on their balance sheets," Bates points out. "And that's great -- that's why they held it in the first place."
Companies with the heftiest cash holdings were able to use them as a source of strength during the crisis, seizing opportunities unavailable to weaker competitors. Take Berkshire Hathaway, the investment company controlled by billionaire Warren Buffett. Berkshire stocked up as others struggled, substantially increasing its stake in several companies and buying Burlington Northern Santa Fe outright.
"One of the reasons why you want to hold cash is because it preserves your options to invest in the future," Bates points out. "When you look at Berkshire Hathaway over the last two years, it's invested in distressed companies and gotten really great deals."
A question for business people is how they might apply Bates and his co-authors' findings at their firms. If they're cash poor, should they increase their cash holdings because other companies have? Or if they're cash rich, should they pay a special dividend like Microsoft did? The answer lies in the calculations that the three scholars did as part of their analysis.
"One of the things that our paper can do for practitioners is give them a model for estimating what their optimum amount of cash would be," Bates says. "Or an analyst could use our model as a first step to identify firms that are holding too much or too little cash."
- "Hold less cash and assume more debt" is a commonly-held financial axiom for companies. Too much cash, the argument went, could make executives lax, encouraging imprudent acquisitions and spendthrift expansions.
- Nevertheless, by 2004 U.S. companies were holding so much cash that their net debt -- debt minus cash, divided by book assets -- went negative in 2004 and stayed there 2005 and 2006.
- That same common wisdom says that managers stockpile cash in order to give them operational freedom from board dictates.
- Co-authors Bates, Kahle and Stulz argue that companies, in putting away cash, are responding sensibly to risk in a changed world.
- The recent recession offered the proverbial proof of the pudding: Companies with the heftiest cash holdings were able to use them as a source of strength, seizing opportunities unavailable to weaker competitors, while companies with insufficient cash found themselves struggling to survive.