Capital Markets

Cash: How Much is Too Much?

Huge cash positions are the enemy of shareholder value. So why do so many CFOs cling on to them?
Ben McLannahanMarch 1, 2003

In Olli-Pekka Kallasvuo’s words, “enough was enough.”

As CFO of Nokia, he’d overseen steady growth in the group’s net cash position since taking over the finance reins in 1998. And at financial year-end on December 31st, the firm’s coffers had swollen to E9.3 billion in cash and cash equivalents, up from E6.1 billion a year earlier. Cutting working capital by E1 billion and accelerating inventory turns, among other measures, helped give the Finnish mobile phone giant the largest cash balance in its 140-year history.

The cash pile, in fact, accounted for 40 percent of the company’s assets; well in excess of industry rivals Ericsson (27 percent) and Motorola (21 percent).

High time, says Kallasvuo, to hand some of that cash to shareholders. In January the E30 billion company unveiled plans for an ambitious share buyback program. Subject to approval from shareholders at the firm’s AGM later this month, Nokia wants to purchase up to 225m shares, equating to around E2.9 billion at current stock prices.

Not that Nokia has a reputation for jealously guarding its cash –typically it pays out between 30 percent and 40 percent of annual earnings, Nokia’s dividend policy is already very generous — the average payout ratio in the tech sector is just 6 percent.

Still, the company’s pile of cash has been growing steadily, and even after the buyback and this year’s planned dividend of E1.4 billion, Nokia will be left with a whopping E5 billion in cash.

Yet Kallasvuo says he can justify that cash cushion. “It’s been discussed a lot here, and interestingly enough a lot of other high-tech companies also have strong cash balances,” he says, citing Cisco (which currently holds $21 billion in cash and liquid investments), Intel ($11 billion) and Microsoft (at $43 billion, the ultimate cash piñata). “All of us talk about the flexibility that a strong cash position gives you, keeping open any strategic options we might want to take.”

But the burning question, not just at Nokia but at a range of companies, is how can their CFOs know whether they’re carrying too much cash? And if they are, should they return it to their shareholders?

Opinions are divided. Indeed, deciding how much cash is the right amount for a business is always more of an art than a science. “You can use financial metrics and ratios but that’s not all of it,” says Kallasvuo. “You really need to look at the industry you’re in, and understand what the market wants. Does the market really feel that you need to continue to invest in research and development, for example?”

In today’s turbulent market conditions, finding the answer is getting tougher and tougher. What’s clear, however, is that finance managers have grown cautious, allowing cash balances to creep up, and in turn, shareholder value to be destroyed.

“There are huge, very dubious ‘revaluation reserves’ and ‘restructuring reserves’ sitting on balance sheets all across Europe at the moment,” says Nigel Manson, an associate at the London office of McKinsey & Company, the consulting firm. “It’s often just a way of separating funds from shareholders.”

According to traditional corporate finance theory, each business has its own “optimal” cash level. Companies that are generating cash, so the theory goes, should hold on to enough of it to cover their short-term expenses and capital expenditure, and also keep a little bit more in the bank as insurance against unforeseen events.

Any extra cash the company makes over and above these needs should be returned to shareholders, via dividends or share repurchases. If the company then discovers a new investment that it wants to make, managers should raise the necessary funds through the capital markets.

Agency Costs

What companies shouldn’t do, is “stockpile cash for a rainy day, in the hope that they’ll find a use for it eventually,” says Robert De Gidlow, a treasury consultant at JP Morgan in London.

For one thing, it’s expensive to hold cash thanks to its negative carrying cost — the difference between the return that companies earn on their cash and the price they paid to get the cash in the first place.

For another, excess cash brings agency costs, whereby companies are tempted to engage in “empire-building” — a term that refers to managers who squander a company’s cash on wasteful acquisitions and bad projects in a bid to boost their personal power and prestige. Raising funds in the capital markets, the theory says, brings greater discipline to investment decisions, reducing agency costs.

Of course, theory is all well and good, but the capital markets are far from perfect, and companies can’t always raise money when they want to, nor raise it at a reasonable price. And so the impulse to hold on to cash rather than tap capital markets — just in case tough market conditions arise — can be tough for CFOs to resist, concedes Henri Servaes, a professor of finance at London Business School.

For companies with volatile cash flows, it can be difficult to raise funds at certain times, he says. What’s more, managers at highly complex companies like pharmaceuticals argue that the sector suffers from “asymmetric information” — the capital markets don’t understand the drug industry and so misprice the securities of drug companies, or charge too high an interest rate for debt finance.

Still, Servaes certainly doesn’t advocate abandoning the capital markets. “Some market discipline now and again wouldn’t hurt,” Servaes says. “Trying to convince the markets that they should give you the capital is probably a process that CFOs should subject themselves to every now and then.”


Though John Bason might agree in principle, he disagrees in practice. The finance chief of Associated British Foods (ABF) has ready access to all the funds he needs at the £4.5 billion (E6.9 billion) U.K. food, ingredients and retail group. At the company’s year-end last September, it held just over £1 billion in cash on the balance sheet. Its current ratio (current assets divided by current liabilities) stood at 3.19, a high figure given that most companies aim to have a current ratio of between one and two.

But in the fast-moving consumer goods sector, a mountain of cash is a valuable strategic asset, says Bason, who’s been CFO since 1999. “It’s all about having firepower on the balance sheet — giving yourself opportunities to look at acquisitions, to build on your existing strengths,” he says.

ABF raided its cash war chest to do just that last year, making a series of quick, all-cash acquisitions. In April, for example, the company spent £235m on Mazola, Unilever’s U.S.-based corn oil business. Six months later it bought Ovaltine, the malt drink brand from Swiss pharmaceuticals firm, Novartis, for £171m.

For analysts like David Laing at Investec Henderson Crosthwaite, an investment bank in London, there’s nothing sweeter than having cash on hand in a buyers’ market. The longer equity prices stay low, the longer ABF will be able to match its financial requirements in its asset base, Laing notes, adding that management has shown “absolutely no proclivity towards empire-building. It’s choosing its shots wisely.”

Still, Bason doesn’t escape pressure to disgorge a little more of that capital. He’s “often reminded” by investors, he says, that the cash pile is earning a rate below that which he’d get if the cash were invested in the operating assets of the business. “To this, we say we need time. You’re looking over a time frame of months, while we’re thinking in a time frame of years.”

To validate his strategy in holding so much cash, Bason points to total shareholder returns. In 2002 (the worst ever year for the FTSE 100 share index, which tumbled 24.5 percent), ABF emerged as the fourth best-performing stock, gaining almost 17 percent on the year.

On top of that the company pays a regular dividend that has moved up ahead of earnings in recent years; for the fiscal year ended September 30th 2002 ABF paid dividends of 13p per share, the equivalent to 32 percent of earnings. The company’s overall return on equity was 11.2 percent, an improvement over the 8.8 percent return the company achieved in 2001. “I’m comfortable with that,” says Bason.

Cash Dispensers

But not all CFOs can reach for such positive performance metrics to justify a cash cushion. In these cases, how should CFOs react to claims they’re holding too much cash?

At the very least, say experts, managers should examine their companies through the filter of financial theory and calculate their optimal cash level from there. By building a model of a business’s future cash flows, its capital expenditure plans, maturing liability payments, and other cash needs, a company’s management can go a long way towards determining how much cash is required to ensure adequate operating funds at a minimum cost.

The problem is that not enough European corporates regularly undergo this kind of exercise, says Theo Vermaelen, professor of finance at Insead, a business school based in France. “They are not that difficult, but I think most businesses are just not cut out to do them,” he says. “Most people tend to look at what their industry’s doing, and assume their rivals have got it right. That’s the wrong approach. Every firm’s optimal capital structure is different, and evolves all the time.”

Stefan Johnsson figured that out a long time ago. As CFO of Volvo since 1998, he knows all about the benefits regular assessments of optimal cash levels can bring. When the SKr189 billion (E21 billion) Gothenburg-based truck giant sold its car brand and manufacturing operations to Ford for $6.5 billion in January 1999, it was left with a product range spanning heavy trucks, bus bodies, engines (marine, aerospace and industrial) and construction equipment.

As Johnsson explains, the removal of cars from the product portfolio meant that Volvo became much more exposed to the volatility of the industrial manufacturing cycle. “From a ratings, banking and wider market perspective, we became much more cyclical,” he says. “If you take the entire truck market, you have 50 percent swings from time to time from top to bottom. You just don’t see that in the car business.”

Hence an urgent review of the automaker’s liquidity management. In the summer of 1999, Johnsson and his colleagues hammered out core steering principles to, as he says, “ensure stability and flexibility throughout the business cycle.” A review of those principles is now repeated every year.

Currently, the three core financial ratios are keeping cash levels between 8 percent and 12 percent of sales; holding committed long-term debt under 8 percent of sales; and maintaining long-term debt and equity plus minimum interest no more than 30 percent greater than fixed assets.

Is Everybody Happy?

“We try to weigh in a fairly complex way the risks we’re facing,” Johnsson says. “In a highly cyclical business like ours, it’s most important that you give yourself opportunities, and that you have a buffer there that you can work with.”

Volvo’s 8 percent-to-12 percent cash/sales target margin, Johnsson reckons, represents the optimal trade-off between maximizing shareholder returns and keeping a level of liquidity sufficient to satisfy lenders, ratings agencies, and Volvo’s own needs. “We don’t want to fall into the trap that other Swedish companies like ABB and Ericsson fell into last year, when they were downgraded a number of times,” he says.

Like many other companies in the truck and auto businesses, Volvo was put on watchlists at Standard & Poor’s and Moody’s in mid-2001 — but has so far staved off downgrades. “It helps, having a strong balance sheet,” Johnsson notes. “If we didn’t have that, we’d have been downgraded a long time ago.” (Moody’s currently has Volvo’s debt on a long-term A3 rating, negative outlook, while S&P has assigned a short-term A2, stable.)

Nonetheless, like ABF’s Bason, Johnsson has grown used to standing before the investor community and defending Volvo’s decision not to funnel more of its cash back to shareholders. The company’s balance sheet showed SKr24.8 billion in cash and short-term investments as of September 30th last year — equivalent to 13.1 percent of 2001 sales.

“There will of course be a constant combat between investors and ourselves on the issue of cash,” the CFO says. “Holding this much cash puts pressure on the operating margin, and pressure on us to see that we deliver.”

That’s why it was important, he adds, that Volvo kept up its dividend in 2002, despite “very ugly” trading conditions. A weak U.S. truck market meant that the company’s operating margin dived to -0.4 percent in 2001 from 5.5 percent a year earlier, excluding divested operations. Return on equity in 2001 was -1.7 percent, substantially worse than the 4.8 percent return achieved in 2000.

Nonetheless, Volvo paid out dividends of SKr8 per share last April, implying a dividend yield of 5.5 percent, up from 4.7 percent a year earlier. The bumper payout came “as a surprise to the market,” Johnsson notes. “But we emphasized we had the balance sheet in good order, since we were able to release some capital from the operating capital.”

Back at Nokia, Kallasvuo is counting on putting across a similar message to investors in a few weeks. He’ll be hoping the buyback silences the calls to return more cash — at least for now.