Pendleton Street Advisors


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The Cash Conundrum for Business Owners: How much is enough?

Successful businesses inevitably end up with cash. During initial periods of significant growth, cash may be in short supply as it is re-absorbed to fund increasing working capital and overhead expenses. But, eventually the business should hit a rhythm and cash will begin to accumulate. As great as this business milestone can be, there aren't many tools or resources available for owners to objectively determine the best uses for accumulated cash. This article outlines a few of the key issues that should be considered, as well as some practical tools to address them. In addition, we look at what data on some of the largest and best-run companies in the world tell us about cash and balance sheet management.

A Good Problem to Have…
The shift in a business from cash-gobbling to cash-accumulating can be a source of anxiety for many business owners. Why? It sends up a signal that something has changed, and living with change takes effort – whether it is effort to ignore or effort to understand. Assuming nothing is wrong, (i.e. nobody overpaid you, you didn’t miss or underpay vendor invoices, you didn't miss a payroll, etc…) it also means another decision must be made:

what are we going to do with this cash?

For some businesses, the answer can seem obvious: hire more people, buy more equipment, ramp up marketing, and on and on. More often than not, the use of cash left off the list is the one most linked to a significant component of why many of us became business owners to begin with: to become financially independent. After all, most business owners are integral employees of their businesses, and in turn become heavily dependent on compensation from their businesses to fund ongoing living expenses.

As an owner, there are just two sources of investment return that come from your business: capital appreciation (price increase) and distributions/dividends. Of those two, only one can contribute to your financial independence while you remain an owner of your business – dividends. That contribution can be significantly more than expected, if dividends are saved and invested. Ultimately, the earlier you start accumulating off-balance sheet wealth, the less dependent you will be on sale proceeds. That doesn't mean you’ll settle for less when you are ready to sell. On the contrary, it could lead you to a better sale outcome, because you will have more of the strongest form of leverage a seller has in negotiations with a buyer: the option to walk away at any time.

But, back to the present, there are two questions regarding distributions that go hand-in-hand:

  1. How much cash does my business need?
  2. How much should I be taking out of the company in the form of distributions or dividends?

As with many questions in business, the answer is: “it depends.” Good news – the information you need to make decisions is usually available, and that's what I will spend the rest of this article outlining. Although some overlap exists between these categories, the answers depend on four management categories: risk management, growth capital, taxes, and bankability.

1. Risk Management: Some business risks require insurance, some require legal protection, and some can be covered by making sure your business has adequate liquidity. Say, for example, that a major customer’s business fails and they leave you holding the bag on a large receivable. You owe your suppliers regardless. While there may be some legal recourse, who knows how long that will take and how successful you’ll be. In the meantime, you still need those suppliers to continue production on sales to all your other customers. Cash would be helpful in that situation.

Another risk related to cash is having too much. Think of this as the Murphy’s Law of cash: “If it can be spent, it will be spent.” To some extent, your expenses are like a goldfish and your cash is like the pond you put it in. The bigger the pond, the bigger the fish will grow. While expense management can mitigate this risk, we have seen businesses time and again succumb to the temptation of spending cash because it is there rather than because it is needed.

One way to determine how much cash to keep on hand is to take a worse-case scenario approach and figure out how much cash you would need to keep the doors open for some time without any additional cash coming in. I say worse-case rather than worst-case because the worst case is complete failure and shut-down. The point of this method is to determine a realistic and reasonable cash reserve, over and above what you’ll require for regular operating expenses; not necessarily one that would protect you from catastrophe. We have seen companies keep anywhere from 15-90 days of additional cash on hand for risk management purposes. Whatever you choose, you can determine the dollar amount of cash reserve by (1) analyzing your expenses, (2) estimating what a normal month’s expenses are, (3) dividing that amount by 30, and then (4) multiplying it by the # of days of cash you want to keep on hand. See the table below for an example. This is not a full proof method, but it will at least give you some peace of mind without leaving too much cash on your balance sheet.

chart 1.png

2. Growth: Working Capital (Accounts Receivable and Inventory) is not the only way that growth gobbles cash. You might also be able to identify major expenditures in the near-term that will require a significant cash outlay. For example, maybe you need a new website; a revamp of your office space; a new office or production plant all-together; new equipment; or a 21st century IT infrastructure. A best-practice we have seen in businesses regardless of size is Capital Budgeting.

A capital budget is different than your annual operating budget. It is the result of sitting down and thinking about what major expenditures you will need to make over the next 2-3 years to support your growth. Having a capital budget opens up a broader discussion of capital structure: what combination of debt and internal cash flow is best for your business? There are ways to determine what amount of debt your company should use, but that is a separate discussion. For now, if you know from your capital budget that you require a certain amount of cash over the next twelve months, don’t distribute it.


4. Bankability: Bankable is a made-up word that means your company is able to obtain and maintain debt-financing at competitive terms.  Bankability is a measure of how bankable your company is. Most banks look at two types of ratios when evaluating a company for lending purposes: debt-service coverage ratios which focus primarily on cash flow, and liquidity & solvency ratios which focus on the amount and quality of collateral. Cash can help maintain liquidity & solvency ratios like the Current Ratio (Current Assets / Current Liabilities), and Debt to Equity (Total Debt / Total Equity). In the 2016 Pepperdine Private Capital Markets Report, a survey of lenders indicated that a current ratio below 1.1 and/or a Debt to Equity ratio above 3.5 would be cause for concern. The survey indicated that 62% and 75% of respondents find the Current Ratio and the Debt to Equity Ratio somewhere between moderately and very important, respectively.

Aside from internally-based methods to determine how much cash is enough, it can also be helpful to look at how other companies are positioned.  For information specific to your company’s industry, trade association journals and periodicals usually publish standardized financial statement data. Also, databases such as the RMA Annual Statement Studies™ and IRS Corporate Ratios© can be a good source of information for companies similar to yours in size and industry.

Alternatively, for this article we reviewed financial information on publicly-traded companies that can shed light on how large companies with many shareholders approach cash and dividends. The data we used is all from SEC filings for companies within the Russell 3000 Index of US companies. We excluded companies in the financial services sector, as well as companies that were missing any of the required data points. The total number of companies included in the analysis is 2,306. The total market capitalization of the companies ranges from $46MM to $740 Billion. 

1. Dividends: Out of the full count, 1,203 companies (52%) paid dividends over the last twelve months. When companies are broken out into 5 categories by size, something interesting becomes apparent: the larger a company is, the more likely it is to pay dividends (see chart below). This trend was more apparent in some sectors such as Consumer Cyclicals and Industrials, and less applicable to sectors known for paying dividends such as Utilities and Telecoms.

In terms of how much is being paid out, rather than measure dividends relative to Net Income (“Payout Ratio”), we measured dividends as a % of Operating Cash Flow (modified “Payout Ratio”). This is closer to a measure of how much a company pays out relative to how much it could pay out. The average for all dividend-paying companies is approximately 32%, but unlike the likelihood of a company to pay dividends, size looks to have little to do with how much of its cash flow a company pays in dividends (see chart below).

Note that the payout ratio as we’ve calculated it above does not include cash spent on share buybacks, which is another tool for companies to return cash flow to shareholders that is usually impractical for privately-held companies with concentrated ownership.  When we added buybacks to the payout-amount, the average payout-ratio increased to 57% from 32%, and the percentage of companies with some form of payout increased to 66% from 52% of companies included in the analysis.

As you can see in the chart above, most of the impact of buybacks is in larger companies. This suggests that smaller publicly-traded companies may be under-utilizing a useful tool. Yet, the takeaway for privately-held companies is that part of growing is determining a policy for distributing cash flow to shareholders. Now that we have discussed the payout-behavior of these companies, we can review the level of cash they retain on the books.

2. Cash: On average, companies in our sample kept cash and equivalents at 9.6% and 6.3% of Revenues and Assets, respectively.  One interesting relationship we found was the highly positive one between cash levels and stock price volatility: The more volatile the price, the more cash a company is likely to keep on its balance sheet. Both are likely related to volatility and levels of predictability in cash flows of the underlying businesses.

This finding is intuitive, but it reinforces the importance of understanding your business and the underlying dynamics of it in determining cash requirements.  If your company is in a highly cyclical sector such as consumer cyclical/discretionary, or high-growth/high-volatility sector such as IT, you should consider keeping more cash on your balance sheet as a cushion for cash flow volatility.

We also calculated Days Cash on Hand for each sector, and by size, and found that sectors with lower volatility keep fewer days cash on hand.

Again, company-size looks to have little to do with how much cash companies keep on their balance sheets relative to other measures like Sales, Expenses, or Total Assets.

This discussion about cash and dividends started among the team at my firm as a result of the work we do with owners of privately held businesses.  While many of the articles I post involve discussions about the sale of businesses in the context of exit-planning, the planning should start long before an owner begins preparing for a sale.  Business owners at any stage of ownership can benefit greatly from considering the gradual increase of wealth outside of their businesses resulting from a well-planned and executed dividend-policy that leaves their companies adequately – not over – capitalized.  

Matt A. Morley, CVA, CEPA
Chief Investment Officer
ArticlesMatt Morley