How much cash is enough cash? As debates in corporate finance go, few are more basic or more persistent. On the one hand, cash supplies a cushion against hard times or a war chest to bankroll growth strategies. Yet cushions and war chests, if judged excessive, invite criticism and occasional proxy battles.
Increasingly, finance executives are becoming critics of high cash balances. “I hate cash on hand. It is anathema to me,” says CFO Fred Salerno of Bell Atlantic Corp.
“The appropriate level of cash, in my opinion, is zero,” declares Salerno.
Zero cash is a tough bar to get near, much less under. But Bell Atlantic is not alone in aiming low. Haverty Furniture, an Atlanta-based furniture retailer, seldom lets cash accumulate. “I prefer to impress people with a low level of cash rather than a high level,” says CFO Dennis Fink. “You don’t make money with cash.”
Not all finance executives are ready to jettison spare cash, however. Take Ford Motor Co.’s stand on appropriate cash levels. “There is no answer for a company this size,” declares CFO Henry Wallace. Until recently, however, Ford’s answer was a treasury bulging with some $24 billion in cash and cash equivalents, nearly half the company’s market value in early June. A recapitalization announced in May will shrink cash by $10 billion.
Short of settling the debate over optimal cash levels, this month CFO introduces a means to survey its dimensions. The first Optimal Cash Scoreboard, a joint effort with PricewaterhouseCoopers, highlights several measures of cash- on-hand at a cross-section of 550 public companies. The Scoreboard tracks: 1) cash levels at each company as a percentage of sales; 2) a target cash level based on volatility of cash flows and cash requirements; 3) actual cash levels versus target levels, or cash gaps; and 4) cash gap per share. The actual rankings presented are based on average days operating expenses held in cash, or DOEHIC, from low to high, over 20 quarters through year-end 1999.
Overall, the Scoreboard found that DOEHIC levels are unexpectedly lean given the unprecedented stretch of record corporate profits and cash flow. Nearly every industry group, from steel producers to manufacturers of consumer nondurables, features several companies holding only enough cash to cover operating expenses for two weeks or less. And the results suggest that companies are rather confident in sustained economic growth and a strong pace of reinvestment.
It would be hasty to claim, however, that companies with leaner coffers are automatically healthier than companies with more cash on hand. The auto industry, for example, has historically maintained high cash levels as a hedge against cyclical downturns. Other companies are saddled with low debt ratings that curtail access to lenders. But given the wide range of cash levels that the Scoreboard documents, it is fitting to ask why certain companies hold cash, why others shun it, and what their attitudes say about their future outlooks. Ultimately, says the Scoreboard’s designer, PricewaterhouseCoopers’s Eric Wright, DOEHIC puts a number on an attitude. “The discrepancies within industries suggest a quantitative assessment of each company’s confidence in the availability of cash in the future,” he says.
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.
To judge which companies are carrying too much cash, Wright says, “look across the various metrics of cash levels in a given industry. If a company tends to carry more cash than its peers, it deserves scrutiny.”
Where the Gaps Are
To increase that scrutiny, the Scoreboard examines cash gaps between actual levels of cash maintained over 20 quarters and a statistical model that computes estimates of minimal required levels. If less cash sits on the balance sheet than might be needed in a crunch, it implies that a company relies on its bankers to cover shortfalls. If the gaps are positive, the excess cash means that a company is most likely operating with a cushion.
Such gaps partially reflect managers’ faith in the banking system. Companies operating with less cash than necessary signal their confidence that banks will lend to them in good times and bad. A large positive cash gap, on the other hand, flags companies whose management fears being left at their bankers’ mercy, either because of onerous terms or curtailed lending.
Here again, the discrepancies in the industry sectors are revealing. In the steel business, for example, Oregon Steel Mills is not the lowest and WHX is not the highest. Instead, average cash balances at Kaiser Aluminum Corp., with six days of DOEHIC, fall short of average requirements by 76 percent, or $105 million. Meanwhile LTV Corp. has the largest positive cash gap, $409 million, more than two and a half times its target level. WHX sits next, with a $317 million cash cap, about twice its target level.
Still, cash gaps seldom get much larger, in dollar terms, than at Procter & Gamble Co. Despite the company’s stable cash flow and lofty AA senior unsecured credit rating from Standard & Poor’s, the Scoreboard records a $1.8 billion positive cash gap.
Using such a sum to reduce short-term debt would add $47 million to P&G’s bottom line, assuming that the giant household-products maker pays 4 percentage points more to borrow money than it can earn on Treasury securities, and a marginal tax rate of 35 percent. Multiplied by the company’s prevailing price/earnings ratio in early June, the fillip in net income would add $1.2 billion to its market capital.
Trust in Bankers
One company that keeps its gap exceedingly wide is Wickes Inc., in Vernon Hills, Illinois. The gap is negative 98 percent, meaning that cash on hand represents only about 2 percent of the sum needed to cover cash flow shortfalls since 1994, the period covered by the Scoreboard. While ringing up sales in excess of $1 billion, the specialty retailer of lumber products maintains about $1 million in cash — just enough to ensure that all transaction costs are covered — and its goal is to get cash as near to zero as possible.
Wickes treasurer Jim Hopwood says the zero target and low cash gap reflect his philosophy that banks should provide cash, not balance sheets. “We work really hard at developing credit relationships,” Hopwood says. “We have a credit revolver if we ever need it. To me, a company has a great relationship with a bank group if it is signed up to get ready to lend.” The company’s current cash facility extends to June 2003. And thanks to a high turnover rate, solid receivables, and progress in reducing debt, Hopwood is confident that lenders won’t vanish when it comes time to renew.
To maintain low balance, every night Wickes outlets deposit cash receipts in more than 100 local banks. The following morning, a standing order empties those accounts by sweeping the cash into a central account at Fleet Bank, where it reduces revolving credit balances. “We pay 1.75 percent over LIBOR for money,” says Hopwood. “The first objective has to be to drive that [balance] down as fast and as far as I can.” Policy appears to correlate with performance. In calendar 1999, Wickes garnered a 14.5 percent return on its invested capital. Competitor Wolohan Lumber Co., with 11 days of DOEHIC, barely chalked up a 9 percent return.
Likewise, at Haverty Furniture, CFO Fink prefers solid bank commitments to hefty balance sheets. “You don’t have to worry about predicting short- term fluctuations in cash flow,” he says. On an average day, Haverty owes about $50 million under the revolving credit agreement, but a peak day can require $80 million. “You just need lenders that will cover peak needs,” he notes. The arrangement, he says, allows him to spend more time thinking about inventory levels, capital expenditures, and other matters of strategic significance.
Substituting credit for cash balances, however, may be perilous, says Samuel L. Hayes III, finance professor emeritus at the Harvard Business School. “There is nothing new about saying cash is a drag,” he declares. “The cash you carry has a very low return. But you have to temper that observation. In a perfect world, you can always get money. But this is an imperfect world, where you have to make sure you have a couple of reserve triggers to pull if you get into trouble. Credit is one; cash is another.” Disdaining managers who live on credit, Hayes votes for constant scenario stress testing and sufficient cash protection on the downside.
Where Do We Go from Here?
What constitutes sufficient cash is still an individual company decision. Still, there is evidence that even the staunchest supporters of cash cushions have their limits. At Ford, treasurer Malcolm “Mac” MacDonald and CFO Wallace resist being pinned down on optimal cash levels, but recently conceded that a $24 billion coffer is more than required. That is hardly surprising. With so much cash on hand, Ford would be vulnerable to a takeover bid if the Ford family didn’t control so much stock.
To lighten the coffers by some $10 billion, Ford unveiled a novel recapitalization plan in April. The so-called Value Enhancement Plan will let shareholders exchange existing shares for new Ford shares plus, for each existing share, $20 in cash or an additional investment in new Ford shares. If shareholders behave as expected, they will shrink Ford’s cash to $15 billion. This sum is sufficient, Wallace believes, to sustain manufacturing and research and development through any foreseeable downturn.
The trend in optimal cash levels, however, seems to be personified at such companies as Bell Atlantic, where every nickel of cash flow eventually finds its way to its facility in Cranford, New Jersey. Whether generated by the domestic telephone business, foreign telephone subsidiaries, or fast- growing wireless operations, cash not earmarked for daily operations or a specific strategic goal is used to reduce the company’s short-term debt. As a result, Bell Atlantic sits with the leanest cash level among 11 telecom companies in the Optimal Cash Scoreboard. The company posted just 10 days of DOEHIC; WorldCom Inc. was next in line with 12 days. And a tight lid on cash levels has not prevented a string of acquisitions since 1998, when Bell Atlantic agreed to exchange stock then worth $53 billion for GTE Corp. (now valued at $65 billion; at press time, the companies were on the verge of completing the merger). Lowering cash levels at GTE, with 20 days of DOEHIC, will be a challenge as the merger proceeds, according to CFO Salerno.
Such diverse philosophies about optimal cash levels will continue to defy conclusion. Still, at Bell Atlantic today, the rules are clear: operating units may not accumulate cash. “We had to jam it a bit at first,” Salerno says. But persistence prevailed, and operating managers are convinced. “If they can execute their business plans,” Salerno declares, “it does not matter where the cash comes from.”
S.L. Mintz is New York bureau chief of CFO.