OLD ARTICLE – Original posted July 8, 2011
Ever heard the term “lazy balance sheet”? Perhaps you’ve heard the term “excess cash”?
They may sound strange, but they are rooted in capital efficiency and the theory of maximizing shareholder returns. But, this is perhaps getting ahead of myself, so allow me to elaborate…\
Return on Equity (or “RoE”) is possibly the single most important ratio for shareholders of a company. It directly influences the profitability of the company, which directly influences the valuations of the shares of that company. Obviously, as shareholders, the higher the valuation of their shares the better.
Basic RoE is made up of two components: Profit After Tax (PAT) which is divided by Equity (often, average equity is used).
Successful companies (that are not reinvesting heavily into operations or acquisitive or organic expansions) generating good profits, can utilize their free cash flows to degear (pay off debt). Once this degearing process is complete, the companies can actually start to build up excess cash balances. Basically, this means that the companies start to sit with large net cash balances that are doing nothing but earning interest for them.
Balance sheets that have these large excess cash balances are termed “lazy balance sheets”, as — although the risk of business failure is a bit lower — the profitability on these balances sheets is dragged down by the excess cash balance.
But, isn’t cash a good thing? How can cash “drag down profitability”?
Equity is the balance left once liabilities are deducted from assets (the “Accounting Equation“). If there is a large excess cash balance, it will inflate assets. This means that equity is higher than it would be without that cash balance, hence RoE is lower than it would be if the company’s balance sheet was kept lean and mean.
Remember, cash will only earn money market rates, while a company’s Cost of Equity dictates that it should earn quite a bit more than just the cost of cash (this is compensate shareholders for taking the risks of entering the said business). Hence, the downward drag on the RoE that an excess cash balance has, sinks a company’s valuation and impacts directly on shareholder returns.
Let me phrase it another way: the equity of a company that relates to operations is valued, say, on a Price Earnings basis that is often many multiples (the Price Earnings ratio). But, cash is only ever valued as cash. In other words, a large excess cash balance will only ever be valued on a multiple of 1.0x itself (i.e. cash is worth a Price Earnings ratio of 1.0x).
So what should a company do with its excess cash balance to streamline its lazy balance sheet?
Simple: generate returns for shareholders. It can do this by reinvesting into its operations or acquisitive activities both aimed at growing itself and, hence, generating capital returns for its shareholders. Alternatively (and the most common method), would simply be to pay the cash balance out to its shareholders. This returns the cash to shareholder pockets and allows each one of them to individually seek returns with that cash elsewhere.
I hope this make sense to you so far. The theory is relatively simple, but the question remains: if this is so obvious, why do directors let their companies sit on excess cash piles to the detriment of their shareholders?
Because of the asymmetrical risk profiles and, hence, asymmetrical motives of insiders (i.e. directors) versus shareholders.
A big way of say that sometimes directors are more looking out for themselves, than looking out for shareholders.
If a Board allows their company to sit on excess cash, negatively impact shareholder returns, it is highly unlikely that the said company will go bankrupt in a case like this. So, if this scenario plays itself out, shareholders will probably under perform the market while the Board will continue to safely pay themselves salaries, directors fees and bonuses.
At least in this case the Board walks away rich.
On the other hand, say a Board takes some risks seeking to maximize shareholder returns and aggressively utilizes the excess cash in such a way that it is no longer there (perhaps spent on acquisitions, organic growth or both). Unfortunately, let us say that these risks do not pay off and the company is eventually liquidated, or, at least, needs a massive turnaround to steer it back on course.
In this second case, the shareholders would also under perform the market as the troubles play out. The major difference lies in what happens to the Board: they are either out of a job when the company is liquidated or out of a job when shareholders sack them and bring in the turnaround crew. Either way, directors lose their livelihoods: their no longer have the company paying them their salaries, directors fees and bonuses.
Can you see how this asymmetrical risk profile pushes directors (of companies that they do not own) to become overly cautious in their approach to managing the businesses. And, in this way, excess cash balances creating lazy balance sheets start to pop up all over the place and it is always the shareholders that carry the long-term cost of this.