Low by Design
Lean cash balances are no accident, says treasurer Wayne Smith in describing Avery Dennison Corp.’s scant cash level — just one day’s worth of operating expenses. “It is all by design and part of a much bigger strategy.” That strategy, he explains, is to use virtually all spare cash to retire short-term debt, and to rely on credit lines in 40 countries for short-term cash needs. “I’ve been doing it for 20 years,” he says, “and it works.”
Besides minimizing interest expense, the policy fine-tunes Avery Dennison’s capital structure. In addition, says Smith, it has contributed to superior financial performance. For calendar 1999, Avery Dennison, based in Pasadena, California, posted a 9.9 percent return on assets, versus 3.9 percent for its peer group, and a return on equity of nearly 27 percent, which outpaced its peers’ 12.3 percent.
“If we kept cash equal to the market basket of companies we compare ourselves with,” says Smith, “we’d have at least 10 times [more] cash. That difference helps us reduce our invested capital base, and increases our return on total capital by about 3 percent. It creates a lot of economic value.”
How widely office-products manufacturer Avery Dennison’s policy differs from its peers is readily apparent in the Scoreboard’s consumer nondurables sector. Its 1 day of DOEHIC is months away from the 105 days of DOEHIC at Just For Feet Inc., a struggling shoe manufacturer purchased earlier this year by Footstar Inc. And the discrepancies are no less jarring in other sectors. Among steel producers, for example, DOEHIC ranges from three days for Oregon Steel Mills Inc., with $820 million in sales, to 155 days for WHX Corp., with $1.7 billion in sales. And in the food and beverage sector, average DOEHIC runs from one day at Conagra to nearly six months’ worth of daily operating expenses at Tootsie Roll Industries.
The ranges, says Fred Kaen, a professor of finance at the University of New Hampshire, in Durham, and co-director of the university’s International Private Enterprise Center, reflect individual corporate responses to the three main demands for cash. Ford’s lavish cushion, for example, exemplifies precautionary demand: “How much do you need to get through a series of hard draws?” Other levels reflect transactional demand, which covers cash for daily operating needs, or speculative demand, which describes the war chests companies elect to build in anticipation of major investments.
Deciding which level is correct, however, is difficult. There are models, such as the Baumol inventory model or the Miller-Orr cash-management model, to help managers decide whether to hold cash or marketable securities. The Baumol model assumes that cash flows are certain and occur at a constant rate per period, Kaen writes in his textbook Corporate Finance: Concepts and Policies. The Miller-Orr model, on the other hand, assumes that cash flows are unpredictable and vary from period to period. Neither model is designed, however, to predict cash requirements, according to Kaen. “The models tell you when to convert marketable securities into cash, not what your cash needs will be in a particular period.