Can A Company Have Too Much Cash?
Having too much cash could mean that a company isn’t putting its resources to good use. In other words, it is losing value by keeping its financial resources dormant when it can be earning more from its investments.
With everything in life, there’s always a trade-off. For every career path you choose, there are tons of others you are choosing not to do and vice versa. In other words, when you take one course of action over another, there is an opportunity cost.
When it comes to the success and sustainability of a company, there are certain things that must be in place and one of such is the availability of cash.
A company needs cash for a wide range of reasons from being able to meet its short term obligations like working capital needs, to being able to leverage opportunities that arise.
Particularly, one of the benefits of having more than enough cash it to prevent cyclical downturns. Cash reserves help companies in industries such as manufacturing can mitigate cyclical downturns by having more than what might be needed in the short-term to prevent losses that could arise.
However, on the flip side, having too much cash could mean that a company isn’t putting its resources to good use. In other words, it is losing value by keeping its financial resources dormant when it can be earning more from its investments. Here’s a rundown of the challenges of having too much cash.
Disadvantages of holding too much cash
It could mean short-sightedness
If a company is heavy on its cash balance so much that it appears to be a permanent feature on the balance sheet, it could mean that the management of the company has run out of ideas on expansion or investment opportunities.
This could, therefore, reflect a level of short-sightedness on the company’s part.
It’s an expensive luxury
Extra cash on a company’s balance sheet is an expensive choice because that cash could always be used for something else to bring even more money in.
This is the opportunity cost of a company having too much cash, as if a company can make some percentage of return on certain investments, that company should be making that investment and not keeping the money stagnant.
It could lead to carelessness
A company with too much cash is likely to be careless and make careless decisions, such as excessive spending, unwillingness to prune expanding expenses, and other negative sloppy habits.
Too much cash could also eliminate the pressure on the management to perform, making them assume that there’s no need to work hard and diligently.
For an investor, it is important to properly assess the rationale behind the high cash balance to determine whether it is for the best or whether it is a sign of inefficiency.
Reviewing a company’s future cash flows, capital expenditure plans, business cycles and upcoming liability payments will therefore do well in unveiling truths about the company's financial position and its long term sustainability.
Written by Lawretta Egba
The October Effect: Myth or Fact?
History has shown October to be a marker of more bear markets than showed in the preceding or following months.
There is a ‘myth’ that stocks decline during the month of October and this myth, much like most myths, was formed as a result of historical occurrences that had taken place over time.
The Panic of 1907, Black Thursday & Black Monday in 1929 (proponents of the great depression), and the tragic stock crash in 1987 – which is said to be the worst decline to take place in a single day, all happened in October! This is what is now regarded as “The October Effect” and many investors tend to be anxious about the month.
While it is true that these event did occur, the ‘curse’ of the month of October might not be as spooky as it seems.
Myth or coincidence?
History has shown October to be a marker of more bear markets than showed in the preceeding or following months. While this might not be predominant in our part of the world, the US has had its own tales – and its reasons are not farfetched.
Top on the list is that in the US, October comes before elections making the month traditionally one of the most volatile for stocks. However, to demystify some of the greatest crashes as highlighted earlier, we can see that the phenomenon might be more psychological than factual.
For one, the events that led to both the 1929 stock crash and the 1907 panic took place in September but the impacts were merely delayed to October. The 1929 crash, for instance, has been argued to have started in February when margin-trading was banned. This panic had occurred throughout the year and was only heightened in October.
While statistics have generally debunked this myth, many investors still maintain a negative perception of the month, thereby presenting an opportunity for wise investors. It could, therefore, present a good opportunity to buy stocks.
A cursory look at all the monthly returns in October dating back to over a century would show no valid data and solid ground to support the psychological perception that October is truly a dark month for investors.
The truth
While many myths do exist in stock markets across the globe, there is no one month where the tides are significantly better or significantly worse. Hence, attempts at predicting the market will more often than not, lead to avoidable losses.
It is pertinent to note, however, that cyclical events do occur. For example, the Nigerian stock market will naturally experience a level of volatility as a result of the uncertainty of the economy.
In these periods, it is important to isolate specific situations and form an informed analysis before making a decision.
So, if there is one thing the October effect proves it is that blindly following the crowd could have you making wrong predictions.
Written by Lawretta Egba.
How Risk Premium Works
Simply put, a risk premium is the extra amount of money you receive on a risky asset beyond its expected return on a similar risk-free asset.
Risk is a normal life phenomenon. Just as there are risks we face daily as individuals, there are risks businesses face as well. However, for every risk taken, the reward too must be worth it.
In a business setting, say a construction company, when employees are given dangerous jobs to do, they carry out the jobs with an agreement to receive hazard pay as compensation for the risks and dangers they face while doing such jobs.
This pay they receive is known as hazard pay and it is synonymous to what we refer to as a risk premium.
What is a risk premium?
Simply put, a risk premium is the extra amount of money you receive on a risky asset beyond its expected return on a similar risk-free asset.
In other words, if two investments entered with the same capital should ordinarily yield N10 million, where one is riskier than the other, the ROI of the riskier investment could be N11 million instead.
The extra N1 million is the risk premium and it is put in place to induce an individual or investor to hold the risky asset rather than the risk-free asset.
Risk premium is a form of hazard pay which investors receive for their risky investments. Risky companies, recognize the risks of investing with them and so, they yield higher returns to investors if they succeed as compensation to them for taking such risk.
When investors invest in such companies, they are aware of the likelihood of losing a large portion or all of their capital if the company does not yield the foreseen return.
One might refer to a risk premium as a valid earnings reward and this would not be far from the truth as it is a true return higher than what investors could receive from investments that are risk-free, such as government securities.
This is essentially the difference between investing in federal government securities and investing in the stock market.
Every investment holds its own risk as the stock market is not always predictable, and so investors are more prone to measure the potential risk of certain investments before they invest.
This prevents investors from investing in companies that appear to have so many dangers because no one wants to lose all their money. But when investors are able to think outside the box and invest in new and “risky” ideas and initiatives, they are more likely to receive higher returns than other investors who invested in already stable companies.
Investments in these stable companies are known as risk-free assets, and their returns do not provide any form of premium or surprise profit. While a risk premium could prove beneficial for investors if the company succeeds, it could also be a great loss if such companies fail.
It is pertinent to note, however, that there are various dimensions to risk. Investors must be aware of the extent of the riskiness of any business and must have an idea of the premium being offered. In other words, if a stock offers the same rate of return that a risk-free asset offers with a high level of risk, then such investment might not be worth it.
Written by Lawretta Egba.