All firms need some cash on hand to operate. Researchers have traditionally believed that more cash is better only to a point. Lorenz Graf-Vlachy casts doubt on this idea and argues that more cash is always much better, at least for firms with great investment opportunities.
In late 2023, S&P 500 companies had enough cash to give almost $8,000 to every person in the United States. That included large technology companies like Apple, Alphabet. and Microsoft. Apple alone reported having more than $166 billion in cash and investments on its balance sheet. To put this number into perspective, that is more than the annual GDP of Ukraine, a country with a population of almost 40 million people.
But is hoarding so much cash a good thing? And how much cash should a company ideally hold? These questions have long been hotly debated by researchers. Of course, all firms need some cash for daily transactions like paying their employees and suppliers. Beyond that, there are two opposing arguments, one for holding little cash, and one for holding a lot.
Having little cash may force managers to be resourceful. It prevents wasteful spending and self-serving actions by executives because it makes resources harder to come by. It means that executives will have to justify expenses better. Basically, the argument is that if there’s more cash, more will be spent. In addition, large cash holdings may concern investors who may ask why the money is not put to productive use. From this perspective, excess cash should therefore either be invested or returned to shareholders in the form of dividends or share buybacks.
On the other hand, having little cash also makes it harder to resolve conflicts within the company. If there is little cash, not everyone in the firm can get funding for their favorite projects, and this may introduce friction in the organisation. The argument is thus that more cash allows top management to make peace within the firm by giving everybody a little something. But which of these perspectives is right, or at least more right?
The likely most influential empirical study on the topic was conducted over a decade ago and found that cash is quite valuable indeed. Specifically, it demonstrated that there is a positive relationship between cash and firm value. In other words, the more cash on the balance sheet, the more valuable the firm. Importantly, however, this relationship was weaker with increasing amounts of cash. Put differently, there appear to be diminishing returns to cash. The underlying rationale is that once the immediate opportunities of having cash on hand are exhausted, the cost of holding cash becomes dominant.
Unfortunately, this study used a measure of firm value that is flawed, at least for the particular purpose of the study. Also, it analysed data only until 2009, but investors might have adjusted their thinking about excessive cash on firms’ balance sheets in the meantime, given the substantial overall increase in cash holdings in US firms. In our recent study, we therefore wanted to put the original findings to the test with an improved measure of firm value over an extended timeframe.
What we found surprised us. In our analysis, we saw increasing returns to cash, both across the original study’s timeframe, as well as in an extended sample until 2019. This means that, yes, cash on the balance sheet contributes to firm value in that more cash leads to greater value. However, this effect does not fade away at very high levels of cash holdings. On the contrary, on average, very high levels of cash contribute disproportionately to firm value!
Why is this the case? When we dug deeper into this surprising finding, we found that it was driven by firms with particularly large investment opportunities. After all, only if a firm has valuable investment opportunities in the first place can cash allow the firm to seize opportunities and implement value-creating projects. Thus, only a high level of investment opportunities may allow the benefits of cash to fully unfold. Firms with low or moderate investment opportunities profit from cash holdings, too, but only up to a point. Beyond the level of cash that is required to meet their transaction needs, the cost of excess cash holdings dominates. Firms with low investment opportunities are thus likely best served by focusing on their deployed assets, returning excess cash to shareholders through dividends or share buybacks, and developing new investment opportunities.
In contrast, firms with large investment opportunities need large amounts of cash to invest in them. In such firms, cash is therefore strongly linked to firm value. This applies to both current and future investment opportunities. We conjecture that investors may highly value cash reserves in these firms because they may have the chance to invest in disruptive changes, such as those brought about by new technologies. Not only do such changes often require large amounts of cash, but they may, if approached correctly, be profitable and in turn contribute greatly to firm value.
For example, technologies like robotics, autonomous driving and artificial intelligence need substantial upfront investments yet offer the potential for firms to secure a competitive edge upon successful implementation. In such situations, investors might indeed see greater value in cash inside a firm than in the firm’s currently deployed assets or in their own alternative investment opportunities if the cash were to be redistributed to them by means of dividend payments.
Finally, holding large amounts of cash also allows firms to signal their investment prospects to the capital markets. Investors may incorporate an optimistic outlook, thereby bolstering the firm’s overall valuation and reinforcing the importance of cash as a strategic asset.
In any case, the old adage is truer than ever: cash is king!
- This blog post is based on Cash holdings and firm value: Evidence for increasing marginal returns, by Maximilian H Theissen, Christopher Jung, Hubertus H Theissen and Lorenz Graf-Vlachy, in the Journal of Management Scientific Reports.
- The post represents the views of the author(s), not the position of LSE Business Review or the London School of Economics and Political Science.
- Featured image provided by Shutterstock.
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