Demerits of Excessive Cash Flows in Businesses
Cash flow is the net amount of cash and cash-equivalents being transferred into and out of a business. At the most fundamental viewpoint, a company’s ability to create shareholders value is determined by its ability to generate positive cash flows, or more precisely, maximize free cash flow.
Cash Flows in businesses refers as bloodline by its own merits. Analyzing the amounts, timing and uncertainty of cash flows is one of the most basic objectives of financial reporting & analysis. Understanding the cash flow statement which consist of operating cash flow, investing cash flow and financing cash flow is essential for evaluating a company’s liquidity, solvency and overall financial performance. Positive cash flow indicates that a company’s liquid assets are increasing, enabling it to settle debts, reinvest in its business, return to shareholders, pay necessary expenses and provide a buffer against future financial challenges. Companies with strong financial capacity can take advantage of profitable investments. They also perform better in downturns, by avoiding the controllable risk of financial distress. Even good companies can fail if operating activities don’t generate enough cash to ensure better liquidity. This can happen if profits are heavily linked with accounts receivable and inventory, or if a company spends too much on capital expenditure. Investors, creditors & other stakeholders therefore need to know if the company has enough cash and cash-equivalents to run its operations and to settle short-term liabilities.
But despite having many merits of cash flows, excessive cash flows can harm businesses in the side of short term and long term prospects. The followings illustration tells how it impact adversely to businesses:
Excess Liquidity has Opportunity Costs: If a business is running with huge amount of cash balance in its balance sheet that supersedes the general & specific requirements of it, it comes with opportunity cost of the excess cash assuming that it could invest the excess amount in good ventures to have good returns. So, businesses lose opportunities to invest while those have excessive cash balance.
Loss of Potential Sales Revenue: Businesses lose potential sales revenue or lose customers when those concentrate too much on cash sales. Close competitors may extract market share by offering credit sales to its customers. By this way companies face difficulties of maintaining its customer base and of capturing sales growth.
Quality Suppliers Switch to Others: Companies which dawdle to pay to suppliers to have excess working capital balances can face some difficulties to maintain business relationship with the suppliers. In that case close competitors can offer prompt payment offerings on raw materials to the suppliers. By this way companies pay much later to high quality suppliers lose long term relationship that may have adverse impact in the financial statement ultimately.
Counterparty Risks: Businesses those have excessive cash balances in their bank accounts are subject to some degree of counterparty risk. At the time of financial distress and liquidity crisis insolvent banks fail to meet obligation of withdrawal of money of the customers. In that case companies those make deposit in poor rated banks face insolvency problem. And even in worst cases companies can go bankrupt.
Inflation is Unhedged: Companies having excessive cash receive a comparatively little amount of interest on their bank accounts than other lucrative investment options like growth stocks, good bonds etc. In such cases companies fail to hedge inflation which ultimately decreases the economic value of business. In developing countries this scenario is very common because of higher rate of inflation.
Fails to Meet Quality Expenditure: Companies with cupidity for cash sometimes fail to meet quality expenditures which have direct & indirect impact on business i.e. staff benefits, promotional expenses, CSR contribution etc. In such cases, companies face difficulties to generate growth & leverage. Failure in staff retention, business promotion etc. can jeopardize companies to sustain.
Despite having some demerits of excessive cash flows, cash flows is very essential for businesses to survive. A proverb says ‘Cash is King”, because it tells about your financial strength. Companies need to assess adequate cash requirements while making budgets & planning measures otherwise excessive amount of cash can be harmful. Good benchmarking techniques can tell financial analysts to figure out the companies having adequate cash balances which is relevant as per its requirements. Otherwise adverse impact can harm businesses.
Akramul Alam, CIMA part qualified
Senior Research Analyst, Royal Capital Ltd.