Risk & Economy » Regulation » Climb every mountain

Climb every mountain

UK corporates are sitting on more cash than they did before the financial crisis. Richard Crump looks at what FDs are doing with it

APPLE NOW has more cash to spend than the United States government does. According to figures released by the US Treasury Department in July, the US has an operating cash balance of $73.7bn (£45.3bn). Meanwhile, Apple stated in its most recent financial results that it holds $76.4bn of cash reserves.

While very few companies are in a situation that compares to the one in which Apple finds itself, the IT giant’s cash reserves represents the summit of a growing mountain of capital held across the world’s largest companies. At the start of the year, UK chancellor George Osborne told delegates at the World Economic Forum in Davos that UK corporates are sitting on cash on their balance sheets equivalent to about 5% of gross domestic product (GDP). The same picture is also reflected in Ernst & Young’s (E&Y) ITEM Club’s four-year forecast, which was published in the spring. The forecast found that UK corporate financial surpluses equate to some 6.6% of GDP.

What will you do with your cash balanceThe situation is repeated globally. Prior to the recession, companies were accumulating cash in excess of what they needed in order to grow, which allowed them the flexibility to navigate the worst of the credit crisis. According to a study published by Deloitte in March, entitled A Tale of Two Capital Markets, finance directors have continued to accumulate cash over the last two years, even as they have cut costs, conserved earnings and reduced leverage in a time of uncertainty. This practice has created cash reserves of more than $9tn across the 9,000 largest companies in the G-20.

With large companies flush with cash, the stage is now set for a major revival in company spending. E&Y figures reveal that stocks have been rebuilt and business fixed investment increased by 12% during 2010. The forecast shows business investment growing by 12.3% this year and another 14.1% in 2012, and also shows non-financial company surplus increasing from £56bn to £71bn.

Decisions, decisions

At the peak of the crisis, finance directors working in just about every company were left fretting over the stability of their balance sheet. They are now faced with the more positive problem of choosing the best way of deploying this capital to create shareholder value.

When it comes to the question of what to do with the reserves, it seems every stakeholder has an opinion. Essentially, the choices boil down to a few options: go on the acquisition trail; invest in R&D and cap-ex projects; finance overseas expansion; or return capital to shareholders through a programme of share buybacks or increased dividends.

“Businesses are suffering the cost of carrying capital on the balance sheet, but they are not sure where to put it,” says James Douglas, partner and head of the debt advisory team at Deloitte.

Takeovers are certainly back on the corporate agenda: the total value of M&A deals involving UK businesses increased by 63% to £23.2bn in the second quarter of 2011 from £14.2bn in the first quarter. However, there is also a real incentive for small and medium-sized companies to invest in R&D, after the government decided to increase the relief on R&D expenditure to be taken off taxable profits for SMEs to 200% from 175%, a number that will rise to 225% in April 2012.

“There is now a better tax return to invest in R&D, so this is a good time to do that,” explains Bobby Lane, head of Denver Chase International, the outsourcing operation of Shelley Stock Hutter. “However, you have to make sure that you have enough reserves. Make sure you watch the risk in your own business and make sure that it is covered.”

But despite the choices that are available to cash-rich companies, finance directors are now loosening their grip on company cash piles and returning more to their shareholders. According to the Capita Registras UK Dividend Monitor, dividends are back to levels last seen before the financial crisis.

Second quarter dividendsIn the second quarter of 2011, payouts from UK businesses rocketed 27% compared with the same period in 2010. This marks the second consecutive period of growth, though these follow six periods of decline, out of a total of seven, since the second quarter of 2009. UK-listed companies returned £19.1bn in total to their shareholders via dividends. This figure was £4.1bn higher than in the second quarter of 2010, representing the largest payouts since the second quarter of 2008. In the first half of this year, dividends totalled £34.1bn, up 19% year on year – the fastest increase since Capita began compiling the data in 2007.

The decision to return capital to shareholders depends on the strategy of the business, says Lane: “What are the aims? Is it to maximise returns for shareholders, or to maximise growth to give shareholders long-term value?”
But for some companies, returning cash to shareholders should be the last resort. It only reflects the fact that boards are bereft of ideas for investing their surplus funds.

“From the shareholders’ point of view, they are keen to receive cash back. But from the company point of view, you probably need to have exhausted all the opportunities to reinvest cash before returning it,” says Jonathan Boyers, corporate finance partner at KPMG. “You are effectively admitting that you can’t put the cash to better use.”

Cash hoards

One of the reasons that finance directors are shunning capital expenditure is that they are uncertain about the economic future. There is a strong risk of a disorderly sovereign credit event in Greece or elsewhere in Europe, which may precipitate a second wave of banking sector difficulties, possibly even leading to the break-up of the euro and the collapse of the eurozone. Naturally, companies fear they may be unable to access credit lines with their bankers and are hoarding cash to protect operations.

“Finance directors are preparing for the worst and having to deal with the next downturn. Corporates are holding on to cash and not deploying it on capital investments,” says Jason Torgler, vice president of strategy at financial risk management company Reval.

As interest rates remain at an all-time low, holding capital is even less efficient than it normally is, although that is not seen as one of the biggest problems to hoarding cash reserves. Boyers also cites the opportunity cost involved.

“Holding on to cash normally has an opportunity cost because the cash is not being deployed for commercial returns. While a number of people are concerned about having adequate cash resources, they are bound to miss out on investment opportunities,” he says.

However, Torgler says that the biggest threat posed by cash hoarding is associated with counterparty risk, a possibility that is only heightened by the spectre of another banking crisis. He says that risk management practices associated with financial risk are now also being applied to cash management.

“A lot of that is counterparty-based – looking at the health associated with institutes holding your cash,” he says. “There is a debate about whether to hold cash in deposit accounts or pump it into money market funds. Yields are low on both, but they are higher on managed funds, as is the risk associated with holding cash in those funds.”

He adds that organisations are also starting to look at the entire cashflow processes and are making stronger decisions related to “data points at which to bring the cash forecast in”. This is a result of the fact that businesses are getting tighter on their cash management and cash forecasting processes.

“They are getting a stronger handle on subsidiary cashflow forecasting and are coming down hard on subsidiaries that do not hold to their end of the bargain. They used to live with it, but now there is more intensity around cashflow,” says Torgler.
Douglas at Deloitte has also observed the move towards holding cash reserves in money market funds. He adds that businesses are starting to spread their money more widely.

“There is a shift from euro to dollar-denominated assets. Being cash rich is rarely about returns; it is about cash preservation,” he says.

With so much uncertainty on the economic horizon, keeping your powder dry in the expectation of better days ahead may not seem like such a bad idea. If the banking world does eventually find itself in the throes of another debt crisis, future financing is bound to become even more difficult to get. Lane at Denver Chase International recommends that companies make sure they have enough cash reserves to run the business in times of distress, while taking opportunities as they arise.

“Companies that do have cash reserves can move quickly,” he explains. “If you spend now and need to put debt in to capitalise on opportunities, it could be hard to get. We see a lot of reports of UK businesses being heavily reliant on debt. As we come out of recession, we have to be a lot less reliant on debt in the future.”

None of this will come as good news for Osborne, who told delegates at Davos back in January that “what I’ve got to do in the next few months is to persuade them to start spending that money”.

Financial balance

Share
Was this article helpful?

Leave a Reply

Subscribe to get your daily business insights