What Should A Business Do With Extra Cash?

Few companies have a lot of cash these days. Holding cash in an inflationary environment doesn’t seem smart, but moving cash in a recession does. Let’s list the specific business options along with the advantages and disadvantages of each. And for this purpose, “cash” refers to bank accounts, money market funds, Treasury bills and other short-term liquid assets.

The context of the discussion is late 2022, when many economists, including me, are predicting a recession. Despite some announcements of layoffs, most companies cannot find the number of employees they want. Supply chain challenges have eased but are still above normal in many industries. And with interest rates rising, the return on cash has improved significantly over last year.

The options, in broad categories, are to withhold cash, pay down debt, buy inventory, buy back assets or pay dividends to owners.

Carrying cash is always a good option, but not always the best option. It is good that it provides options for the future, which may include any of the other possibilities discussed below, but the decision may be delayed. There is little downside risk to holding cash, and it enables us to capture opportunities that may arise in the future. With inflation, the purchasing power of cash declines over time, but at least the dollar value of the asset does not fall.

And today—unlike a few years past—cash pays off. Three-month Treasury bills, risk-free until the United States completely collapses, are paying a little over four percent interest, as is commercial paper. Smaller companies can find CD rates attractive.

Another option is to pay off the loan for the business. In most cases, the interest rate on bank loans will be higher than earning cash. However, there is a big strategic difference between paying off a credit line and making early payments on a term loan. Paying off a credit line saves interest expense and maintains the ability to tap into that line in the future. Banks usually pay off a line as a sign of financial strength. Just as cash provides options for the future, a credit line provides similar options.

Paying off a term loan is different. On many business loans, a prompt payment fee will be charged. And equal monthly payments are usually required, so if the business needs cash after a few months, it’s in trouble. A better plan in most cases would be to set aside cash for loan payments in an interest-earning account. The spread between interest expense and interest earned will be negative for the company, but it is offset by the flexibility of having cash on hand if circumstances change.

Buying more inventory is an option that may not have been considered a few years ago. If the company sells goods that are quickly out of date, seasonal, or at risk of theft, it’s probably a bad choice. But, as an example, consider a distributor of nuts and bolts. Fasteners will eventually be sold. The company is protected from supply disruptions. For manufacturers, an increase in finished goods inventory avoids plant shutdowns due to illness among workers. Inventory shouldn’t increase by much, but a little more cash could be a good use.

Buying a property can also be considered. They can be capital equipment, such as computers, trucks or machinery. Or the asset may be another company. Or real estate that will eventually be used for expansion. The current tight labor market argues for using substitute equipment for workers who cannot be hired. The downside is that once spent, that cash can’t be used to stave off a recession. Thus, a cash flow projection should precede a major capital purchase under a recessionary forecast. At this time, most of the devices a company would consider are on back order, as other companies are looking to do the same. Better deals may become available when we go into recession, and the labor market may ease as well – but only temporarily.

Buying another company to compete or expand geographic footprint is always a risk but sometimes it is an excellent option. Make sure the valuation includes a potential downturn, not just a retrospective look at recent profits. Like capital expenditures, run cash flow projections ahead of time.

The best deals are available during or immediately after a recession. So a company looking to be acquired should be patient until more severe pain strikes potential targets. But if an opportunity opens up, say due to the death or retirement of another business owner, the ability to act quickly can enable a purchase at a good price.

Finally, paying cash to owners in the form of dividends is a possibility. From a narrow business perspective, this is a bad choice. But businesses are not started just to be a business; Money is invested by the owners to earn a return on investment. If the owners want dividends, there is no point in arguing with them. (If the dividend could impair the ability to repay the loan, consult an attorney first.) Sometimes the owner of a closely held business needs a large dividend from one company to sustain the other. This is a reasonable option. However, if the management team makes the decision, they should remember that cash provides a great deal of flexibility to weather tough times and take advantage of future opportunities.

Cache is good, because some uses of cache are good. And sometimes grabbing those opportunities now is always better than waiting for better opportunities. But sometimes not.

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