Excess Cash
The GAAP treatment of cash and cash equivalents is straightforward. Cash and cash equivalents are included on the balance sheet as current assets, and any associated dividend or interest income from the investment of cash is recognized on the income statement.
Economics of Excess Cash
Cash is cash--its "book" value is its market value. (The exception to this, cash in denominations other than U.S. dollars, is treated elsewhere).
Companies need to keep a certain level of cash to operate their businesses with timely payments to suppliers, employees and others. Cash that companies maintain in excess of this "required" amount is "excess" cash, meaning that the company does not need it for day-to-day operations. While it is impossible to draw a precise line between required and excess cash, it is plain that at some point cash balances accumulate above this fuzzy and constantly changing threshold.
Companies normally invest excess cash balances in short-term securities that typically return much less than the companys cost of capital. This might seem to hurt a company's EP performance, since the low returns on marketable securities should drag down the average return on all capital while, as EP is normally calculated, the cost of capital remains unchanged. However, the excess cash isnt invested in the risky, returns-producing part of the company. Instead, it is invested in low-risk, short-term securities that, by definition, pay returns equal to their cost of capital. Thus, excess cash balances neither contribute to nor subtract from EP since their earnings always are equal to the cost of capital for the securities in which they are invested.
When looking at capital and cost of capital for the whole company and its mix of assets, increased levels of cash in proportion to other assets should theoretically result in a lower average cost of capital. As a practical matter, it would be impossible to manage a changing cost of capital based on changes in asset mix on a continuous basis.
Behavioral Impact
While excess cash does not contribute to higher EP, interest income on the cash does get counted as earnings. Therefore, if managers are focused on earnings, more cash will always look better, and managers will have a bias toward accumulating cash. Shareholders, on the other hand, usually distrust managers who keep large accumulations of unnecessary cash around without a credible, value-creating strategy for investing it. Such distrust stems from the belief that having too much cash on hand can weaken discipline in the capital budgeting process, encouraging management to think of cash as a "cheap" source of financing.
However, treating cash as though it carries the full weighted average cost of capital can induce just the opposite behavior by managers. Cash earning "riskless" (albeit appropriate) returns invariably reduces EP as cash balances grow. This trend encourages managers to rid the company of excess cash, but may also encourage managers to get rid of required cash. Operating management may want less cash on hand than Treasury deems prudent. In fact, operating managers may fear that they do everything right in terms of collecting receivables, turning inventory, etc., yet end up penalized by Treasurys failure to carry out the last step in the cash management chain--i.e., reinvesting the cash. Alternatively, Treasury may be concerned that operating management wants to keep cash balances so low that they will impinge on financing flexibility.
Both of these concerns can be addressed in one of two ways: either by insuring that operating managers and Treasury fall under the same measure of EP, or by separating excess cash from the net assets of the operating business unit (and the interest income generated by that cash from net income). In the latter case, excess cash could then be segregated under the EP of Treasury, i.e., Corporate, or as a "non-operating" asset, away from anyone's EP.
Alternative Treatments
To effectively consider the alternative treatments for cash under EP, we need to answer certain questions:
- Who is responsible for maintaining cash balances? The business unit, or a higher level entity (i.e., corporate)?
- Do cash management policies currently encourage or force the business unit to send cash to the higher level entity (if there is one)?
- Is there a reasonably objective and reliable method for determining the "required" level of cash?
If a business unit has any significant cash in its net assets, then we must ask whether the business unit has any control over that cash, i.e., do they decide to "hold" the cash in the business units net assets or "push" it up to corporate. If the business unit does have control over cash (or if it is a corporate entity) it must be decided whether and how to treat the cash balance and its interest income. The decision made for the treatment of cash for a business unit of a corporation may be different from the treatment of cash for the corporate parent.
Option 1: Include All Cash and Cash Equivalent Balances
Business Unit Treatment
Most companies tracking EP charge themselves for all cash, and credit themselves for all interest income, even if cash temporarily balloons due to the imminent need for unusual financial flexibility, as with acquisitions or share repurchases.
At business units below the corporate level, cash balances and interest income are typically excluded from EP since individual business units generally have little say in how much cash is kept on their balance sheets. Their cash is generally swept upstream continuously or periodically or as corporate deems necessary. Business units generally should not be charged for enlarged balances if they have little or no flexibility in reducing them.
In certain instances, however, business units do need an incentive to manage cash directly or be accountable for large cash balances. For example, business units may be operating internationally in unstable exchange rate environments. In such cases, the company may be better off having the business unit convert foreign currency into home currency as soon as it is received and send the cash up to corporate as soon as possible. These are functions residing at least partly within the business unit.
For some international operations, repatriation of cash may have severe tax consequences, and corporate may properly prevent the cash from being removed from the business. The business unit may then be charged for such cash balances, even if they have no control over repatriation or re-investment of that cash, since the tax laws and investment opportunities that compel the growth of those cash balances are a necessary part of doing business there. In other words, high levels of cash "trapped" in a foreign operation may be considered "required" cash since the shareholders, by virtue of having operations in that country, have restricted their opportunities to access that cash. These operating decisions reside at least partly within the business unit. The cost of capital, however, should reflect those large, low risk cash balances in the capital base. Those levels of "required" cash should be weighed, before investment in such operations, as a cost of doing business in such areas.
