Corporate finance executives began removing their fingers from the dikes damming up their companies’ towering cash holdings last year, a study of cash management done for CFO.com by Hackett-REL, a consulting company, suggests.
Breaking a three-year trend, the average of cash as a percentage of revenue dropped in 2005 for the sample of about 900 U.S. companies. Starting in 2002, when companies amassed 9.7 percent of their revenues as cash, they socked away rising amounts of the stuff in 2003 (10.5. percent), and 2004 (11.1 percent). Finally, the average fell to 10.4 percent last year. (Download the 2006 Cash Management Scorecard.)
If that trend holds up for 2006, it will likely mean that companies are finding that investments in such things as acquisitions, share buybacks, and dividends are more desirable than maintaining lofty credit ratings. “Since cash is coming down, [companies] must be more comfortable” with the investment climate, says Henri van der Eerden, a director in the working capital practice at Hackett Group. “It’s a tradeoff between return on capital employed and earnings per share and keeping enough cash on hand to keep the correct debt grading.”
The survey also found that in turning loose that excess cash, companies were also turning a profit. For one thing, the average impact of paying down debt and equity rose slightly, from 1.2 percent to 1.3 percent, from 2004 to 2005. More importantly, it increased from a higher base: last year the companies recorded an average return on capital employed (ROCE) of 16 percent, rising from 15.2 percent the previous year. “The bar has been raised,” van der Eerden observes. (See “Calculating the Cash” below.)
Clear as the trend to unleash cash might appear, however, there are some whopping outliers of cash outlays that skew the survey results somewhat. Chief among them was Microsoft’s payment of a $32.64 billion special dividend December 2, 2004. (Since Microsoft’s fiscal year ends July 30, the huge disbursement was reported in the company’s 2005 10-K.) That payout brought down the scorecard’s entire cash vs. sales mark by 0.4 percent, so that had Microsoft not paid the dividend, the survey would have recorded 10.8 percent figure rather than its current 10.4 percent figure for cash as percentage of sales, according to van der Eerden.
The software sector also sported Oracle, another huge user of cash in 2005. But the company unleashed its locked-up funds on another target: acquisitions. In January of 2005, for instance, it acquired PeopleSoft for about $11.1 billion, following that up in April with the acquisition of Retek for approximately $700 million. Not surprisingly, Oracle’s cash as a percentage of revenue dove from 84.6 percent in 2004 to 35.9 percent in 2005.
Still, there are indications in the scorecard that the purse-string loosening was more widespread than the results of the software giants’ activities might suggest. Last year, just 31 industrial sectors out of 76 in all boosted their cash-as-a-percentage of sales figures, according to van der Eerden — a hefty drop-off from the 47 out of 78 that experienced gains in 2004. “The fact that the overall number came down was not because of one or two companies or sectors,” he says. “It was a broad movement across the majority of sectors.”
But is the trend continuing in 2006? While Hackett will wait to tote up the score until all of this year’s results are in, a survey released in July by the Association for Financial Professionals suggests that many companies are still tightfisted. Forty percent of 342 corporate finance professionals surveyed in May said their companies carry a larger U.S. cash and short-term equivalent balance than they held six months earlier; 24 percent reported a decrease; and 36 percent said there was no change.
Indeed, 27 percent expected their companies to boost their cash balances over the next six months, according to the survey. About 25 percent think their organizations will let some cash go, while nearly half expect no change.
Even so, the parsimoniousness may be abating. Indeed, in a speech before the American Enterprise Institute in July, Federal Reserve Board Governor Kevin Warsh cited a change in business attitudes. Cash “has started to decline and borrowing has picked up,” he said.
During the past few quarters, cash-to-assets and cash-to-investment ratios have fallen, and the debt-to-asset ratio edged up in the first quarter of 2006, Warsh noted. The reason for the changes, he thinks, is growth in shareholder buybacks, dividend offerings, business spending, and corporate acquisitiveness.
To be sure, factors like the rise of terrorism and increased regulatory scrutiny in the form of Sarbanes-Oxley have made corporations unusually risk averse of late. Still, the Fed governor says, “it appears that firms are likely to continue to draw down their cash balances from the elevated levels witnessed during the past few years.”
Calculating the Cash
To put together The 2006 Cash Management Scorecard, Hackett-REL used public information reported by approximately 900 U.S. companies to calculate the returns that they would generate by using the excess cash on their balance sheets to pay down “capital employed.” For the purposes of the scorecard, the researchers define capital employed as short-term debt (including notes payable) plus long-term debt plus equity and cash as cash plus cash equivalents plus marketable securities.
To gauge the opportunity cost of retaining excess cash, they first figured out how much of a company’s cash exceeds its industry benchmark, which Hackett-REL determines to be the lowest quartile in a given industry as a percentage of sales. Then they subtracted that excess from the amount of capital a company employs. The company’s return on capital employed (ROCE), based on 2005 pretax operating profits, was then compared with what the return would be after excess cash is used to reduce the amount of capital employed.