The Value of Corporate Cash: Part II - Restricted Capital

What is restricted capital worth?

Part II of our analysis looks at the valuation process. Is a dollar in the bank equal to a

$1.00 on the balance sheet? After reading the cfo.com/cash-management article it is very rational to believe that value is indeed relative. It is imperative to know how the is cash going to be used when it is put to work. The chart below (data provided by CFO.com) illustrates the methodology; how the return on the dollar is dependent upon the company’s position and their investment targets or allocation strategy.

Permanently Reinvested Earnings (PRE)

Companies will spend cash in different ways depending on their positon in the growth spectrum, i.e. startup, early growth, mature growth, and aging decline. Some use cash to generate growth while others payout cash via retained earnings, as dividend payments. Cash is more valuable to companies with viable investment opportunities!  

We know the world is full of low-margin companies struggling to produce a profit as are the companies with limited access to capital markets. These companies will not generate a high return on cash, due to the industry and their position in the corporate lifecycle. Financial markets reward promising startups by providing access to capital. Investors seek out these companies to generate higher returns on their investments.

Companies that typically do not produce a high return on cash are the established blue chip companies that pay dividends and have easy access to capital, companies paying off current debt, or companies with limited growth opportunities.

 

“Once a company is “producing capital” or generating more earnings than it can reinvest and earn profit, the value of a retained dollar quickly falls below par. For companies with the highest credit strength, as represented by having a commercial paper program, balance-sheet cash is worth less than half its face value.” (Hans Tallis)*

*CFO.comhttp://ww2.cfo.com/cash-management/2014/11/the-value-of-cash-do-not-post/by Hans Tallis, Contributor

"Value is indeed relative to the uses and parties involved in transactions, especially when it comes to financial reporting and Wall Street."

The Efficient Use of Capital

Would you agree that cash is a commodity? Did you notice a correlation between a companies use and the corresponding value of the cash? The value of cash appears to be dependent upon the use and the parties involved in the exchange. It is clear that companies with high research and development costs, high capital expenditures, and growth potential are the most efficient at using capital. The middle three companies are ones that raise private capital or have a well establish source of revenues from different sources (diversified income), and those that raise capital in public markets.

Then there are companies that are net distributers of capital thru dividend payouts or they are in a low growth phase, and then there are companies that rely on the commercial paper markets for funding. Regardless of the phase or potential of these companies, the authors established a value-oriented analysis of $1 for companies and their shareholders.

Where is the Value?

We have just discovered the numbers on a financial statement can be quite deceptive and misleading. The risk of relying on misleading information still exists in spite of new regulations and oversight of the financial markets. This scenario is very disturbing and challenges the enforcement of reporting standards. So it appears, a dollar is not always equal to a $1.00. Value is relative to the uses and the parties involved in transactions, especially when it comes to financial reporting and Wall Street.

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Select articles from 'Your Business Matters!'

 Can You Answer These 10 Questions on Interest Rates?

 Cash flow Statements: Operating, Investing, and Financing -  
   Revenue or Other Comprehensive Income?

How to Measure the Value of Corporate Cash

The Value of Corporate Cash

By Nicholas Morris

Corporate balance sheets can sparkle with big cash balances and excessive current assets. The money is in the bank, it's just not a local bank. The following article explores the basis of economic value concerning cash, liquidity, and accounting statements of publicly-owned companies. Dedicated to shareholders everywhere.

Growth Strategy

What is the goal of a public company? Usually a company’s highest priority is to create wealth and to return capital to shareholders and investors. Companies do this by investing capital to make money, investing in assets like plants and equipment, carry out research and development, and they also invest in other companies or buy them. Two main strategies are 1) the acquisition strategy or buyout, is quite different from 2) the organic growth strategy that builds revenue from the ground up.

Growth requires assets and cash (also includes short-term investments such as Treasuries or CD’s. Cash is the most liquid current asset. In this article we are not looking at growth models per se, but how cash is used by different types of companies to achieve growth. Opportunities for growth vary with the firm’s industry and maturity so it is important to note industries vary greatly in how growth is acquired. Essentially, cash is most valuable when value-adding opportunities exist for the company. It’s not surprising, therefore, that cash is deemed more valuable to early-stage firms whose prospects and outlook depend on research and development and other investment expenditures to generate returns.

Many products and tools developed ten years ago have been replaced with new ones. The notion that tomorrow ideas will be more valuable than today is the essences and driver of innovation. Companies invest to get ahead and stay competitive in their industry.

Where’s the money?

When we analyze multi-national companies currently based in the U.S. we will look at their accounting methods closely to understand where revenue comes from, where it is being spent, and how returns are generated.

Tax inversions are at the heart of this discussion. The amount of corporate cash stashed overseas has been building in the last decade. To answer the above question we look at the MD&A in financial statements and we see massive quantities of cash parked on balance sheets over seas, sitting idly in a foreign bank earning very little interest.
One of the problems with the accounting process for this cash is that it is classified as a liquid current asset. Cash is the first category under current assets, usually! This cash is stashed in an off-shore account and as Twitter’s financials explained in the MD&A, ‘it is not expected to be moved or expatriated any time soon.’


Basically, the cash being held classifies as restricted cash, in the foreign bank where it is stashed. Having said this, it clearly will not be returned to the U.S., without losing a larger percentage to taxes, and therefore is not a current asset but a restricted asset that could be classified as investment capital.

TECHNICALLY - Cash flows are susceptible to liquid investment classification issues. 

Look for liquid investments that do not qualify as cash equivalents and are included in cash flows from investments. Compare to cash flows from operations.

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Liquidity Survey Key Findings July 2014

AFP* Liquidity Survey 

This survey sponsored by RBS Citizens received 740 responses from a diverse group of companies to gauge the latest ideas financial managers have and the challenges and opportunities they face in today’s marketplace.


What you should know about your business can be complex. Let's get rid of complex and make it accessible, quick, and painless. The PDF report is available on the AFP site and can be accessed online or downloaded. The following summarizes the survey and highlights what the business world is doing with their cash and explains why. There are many tables and charts in the report that do a great job of putting the data in perspective; get the download and check it out!. 

Notes: The Fed reduces QE gradually through 2014 followed by a rising federal funds target rate into 2015. Corporate cash accumulation growth has slowed, spending increases - growing confidence of US businesses in -capital investments, hiring workers, increases in acquisitions, dividend payouts, and repurchase of company stock.

Unchanged are large balances of bank deposits - cash rules in deals and mergers. Largest level of cash holdings to date - 52% of all cash holdings are in banks.  In 2008 companies held only 25%. Why? – currently no other liquid options for cash. The benefit comes from banks Earned Credit Rates (ECR’s) where large cash reserves reduce a company's banking fees.


There are some changes on the horizon for money market mutual funds and the net asset valuations. It could be that certain government and institutional MMF's will not have a floating NAV due to possible "run on assets" federal officials are concerned about. This is important because MMFs have been a large part of short term investments for many global companies. #MMF regulations - SEC changing rules on NAV and floating price - TBD.

Updated 2/2015. You can download recently updated reform rules: "SEC Adonpts Money Market Fund Reform Rules"

Liquidity

36% companies report cash balances increased year over year from the 1st quarter of 2013 to 1st quarter of 2014.
Less than 25% of companies reduced cash holdings.

What has built up cash balance?

• 73% have greater operating cash flows
• 18% are taking on debt – spending not in cash.

What has reduced cash balances?

• Increase capital spending 
• Decreased cash flows
• Retiring pay off debt
• Acquisitions and new operations investments
• Stock repurchases and dividends - push share prices up 

Currently 70% of short term investments are stashed in maturities less than 30 days.

Cash flow Momentum Velocity Depth & Capacity

The Past 12 Months

Interestingly, the past years trend differs slightly for companies that are net investors versus net borrowers, (financing growth can come from debt or equity). 40% of investors increased cash reserves compared to 28% of borrowers. These results can be seasonal as well as a reflection of the company's economic environment.

60% of companies studied hold cash overseas, usually where the cash was generated. Recent cash valuation from CFO.com point out the real value of corporate cast stashed overseas (Restricted Cash) is not on par with IFRS. Logically, growing markets need funding whether internal or debt oriented. 75% of publicly owned companies hold cash abroad while a third of these has at least half of their cash overseas. The study reveals larger companies are more likely to have more cash outside the US. This may be attributed to the necessity for more liquidity to cover global expenses and operating costs for expansion in emerging markets.

Looking Forward

Forecasts for the next year indicate over 75% of responding companies expect cash levels to increase as a result of growth in operating cash flow while (17%) accredit a better cash conversion cycle and (16%) a decrease in capital spending. Companies expecting a decrease in cash levels believe decreases will be the result of increased capital expenses, (25%) paying down debt and (24%) from acquisitions. While less that a quarter of the respondents (22%) expect a decrease in cash due to a decrease in operating cash flows.
Overall, the largest majority of respondents foresee an increase in cash from operating cash flows. The minority cite better short term AR/AP management, and changes in capital expenditures. For those companies anticipating a decrease in cash holdings the majority attribute an increase in capital expenditures, retiring debt, and acquisitions.


How do companies invest in the market when 70% are in maturities under 30 days?
Corporate Investment Policy Statement (IPS) is a written document that outlines the details of the company's plan for putting cash in specific vehicles that may include cash deposits, treasuries, commercial paper, and others like money market funds.

Many larger companies and those that are net investors are more likely to also include a cash fund for liquidity, separate from invested short term cash deposits.

  Priorities in 2014

• Safety (68%)

• Liquidity (28%)

• Yield (4%)

The order above is a direct result of the ultra-low interest rate environment. These numbers and priorities will change as the Fed exits the QE program and subsequently begins to increase the federal funds rate.

Permissible Investment Vehicles

If we look into the chart on page 13 of the report you can see how different companies, i.e. public, private, net borrower, net investor, and companies under or over a $1 Billion in revenues choose to invest. Companies have different needs and plans that should be reflected in the way they invest or borrow. For example, companies with revenues over $1 billion invest more in Treasury bills than companies with under $1 billions in revenues. This is based upon the surveys percentage of respondents. The same appears to be true for net investors when compared to net borrowers.

So who do you think would invest more in the short term, a public company or a private company?

How Can an Investment Policy Statement Diversify?

Many companies have a limit on the types of vehicles that can be used in the short-term. The limits will keep the funds distributed in order to minimize risk and yet offer liquidity. As the chart below indicates, the variety of investment vehicles can be extensive or limited not only in choice of vehicle but also the percentage of the portfolio.Looking at the chart below, 62% of companies surveyed have a provision in their IPS that allows for 50% or more of their short-term investments to be in a bank deposit account. That could be a ton of cash. What it does not tell us is that the funds may be distributed to several or many different banks in different geographical centers which would offer another level of diversification.** 

**This was a suggestion to distribute funds to prevent a lock-out in AFP's Risk Survey for 2013 

Allowable Percentages

AFP thanks RBS Citizens and Citizens Bank for underwriting the 2014 AFP Liquidity Survey. The Research Department of the Association for Financial Professionals designed the survey questionnaire, analyzed the survey results and produced the report and is solely responsible for its content.

*Association for Financial Professionals

4520 East-West Highway, Suite 750

Bethesda, MD 20814

www.AFPonline.org

YOUR BUSINESS MATTERS

Questions or Comments?

Working Capital Management, Cash Flow, & Accruals Analysis

How do you define value? 

The answer probably depends on your occupation or how you play; (investor, owner, manager, banker, etc.) Do you use financial statements to evaluate a company's performance and draw your own conclusions? So, how do you define value? 

I think people use intrinsic value to meet their own needs. How we go about finding value is very relative to who we are, what we do for a living, and what we believe is important. I want to share with you a way to look at a company's financial statements to uncover common areas that could classify as misrepresentation. But first, the public companies we invest in are required to submit financial data and information to the public in CPA format. Systematically defined and qualified under US GAAP guidelines. Even with these rules, and even more rules, and bureaucratic overload, the scandals and catastrophes continue and always will.

Our goal is to find out what the company is really doing under all of the accruals, deferrals, off-balance sheet shit, and hedging. We want to find the quality of earnings, find out how consistent the revenue is, how much cash is collected, and the bigger the company - the harder to sift through affiliates and SPE's to get the complete story. Quite often, a company does what is necessary to stay afloat in the eyes of the market, right or wrong, revenue and profit margins are king and short-term results dominate.  

When we see companies re-state earnings more than once, we should investigate. Look closely. Look for comments that indicate an adjustment to a previous report or an error that created a material difference in the report.

Recently the blog Grumpy Old Accountants by Dr. Catanach, a professor in the School of Business at Villanova University, caught my attention. Check out his bio, history, and current work. He drills down and shows how specific companies report these incidents. Exception: He doesn't think they are just 'incidents'.

A good analyst should be able to breakdown a company's financial statements into values relative to the current economic environment. If a company has unearned revenue, the fact that the company has not received payment should be clear in the financials. Often the analysis pivots on what is real and what is reported to be real. Many banks and investment firms have the same purpose in their analysis and that is to assess the value of a business if it were going to be bought, sold, or liquidated.

I have a few worksheets that help highlight areas of interest where a deeper look may lead to further insight. But first, three very relevant questions for you to consider:

1. What type of business is being assessed?
2. What is the purpose for the analysis?
3. Do we have the proper data for an analysis?

The areas to be examined and uncovered depend on the type of business and the purpose for the analysis. It is important to use the appropriate numbers for an accurate analysis. The sheets are fairly straight forward regarding the inputs, but if you should have a question please ask.

Here's a quick presentation on liquidity:

Can You Answer These 10 Questions about Interest Rates?

1)   Why did interest rates change over the past year? 

2)   What is Interest rate elasticity? 

3)   How would an increase in government spending affect the rate of interest? 

4)  What happens to interest rates during a recession? 

5)  How are expected interest rates linked to an expectation of economic growth and inflation? 

6)  What is the link between the nominal rate of interest and real rate of interest? 

7)  When stock values experience a drop and investors sell, interest rates usually                         decline. How does the selling  of stocks lead to lower interest rates?

8)  How would expectations of higher global oil prices affect supply and demand for loan-able funds and interest rates in the United States? Will the change apply to the interest rates of other countries in the same way?

9)  Why might we expect interest rate movements of established countries to have a higher correlation in recent years compared to historical measures?

10) How does government borrowing and the national deficit level affect interest rates?

Write down your responses here or there and I'll go find the answers. By the way, if you have any questions of your own or want to add a question to the list please do. There are no wrong answers, only right ones!

BONUS Questions!

A) What is Interest Rate Risk? and  B) Who is at risk?

Answers!

1) The Fed began to wind down Quantitative Easing which is a reduction in the amount of Treasuries they purchase and amount of cash going into the economy. This is like taking your foot off of the gas when driving a car. It does not include braking to slow down which is akin to raising interest rates. Although the economy will perceive rising rates when QE winds down. Look at the housing market for example. Rates are scheduled to increase in 2015, of course there is no guarantee in future Fed actions.

2) Interest elasticity of demand represents the change in the quantity of loan-able funds demanded in response to a change in interest rates. 

3) The governments demand for money would create a demand for loan-able funds which would have a tendency to push interest rates up. 

4) During a recession companies tend to reduce spending and  borrowing. The result is a reduction in demand for loans and a drop in interest rates. 

5) Interest rates in the future should increase if economic growth and inflation are expected to rise; decrease if economic growth and inflation are expected to decline. 

6) Nominal interest rate is the quoted rate while the real rate equal the nominal rate minus the rate of inflation or  nominal rate =  real rate + inflation. We are not including any other risk premiums here.

7) When stocks go through a sell-off the money typically goes into money market accounts creating an abundance of loan-able funds and thus lowering interest rates. 

8) Expectations of higher oil prices creates concern for higher inflation. Since higher inflation can increase interest rates, it will cause an expectation of higher interest rates in the U.S. Firms and government agencies may borrow more funds before prices increase and before interest rates increase. Consumers may use their savings to buy products before the prices increase. Therefore, the demand for loan-able funds should increase, the supply of loan-able funds should decrease, and interest rates should increase.

The impact of higher global oil prices in other countries is not necessarily the same. If the country produces its own oil, it can set the oil prices in its respective country. If it can prevent high oil prices in its country, then the prices of products (gasoline) and services (transportation) may not be affected. Therefore, interest rates may not be affected. 

9) Interest rates among countries are expected to have a higher correlation in recent years because financial markets are more geographically integrated. More international financial flows will occur to capitalize on higher interest rates in foreign countries, which affects the supply and demand conditions in each market. As funds leave a country with low interest rates, this places upward pressure on that country’s interest rates. The international flow of funds causes this type of reaction. Also known as carry trade. 

10) When the government has a high borrowing deficit, the national interest payments on the loans are higher which reduces the amount of funds available for lending, driving up the rate of interest. When the  deficit is low, there are more funds available and interest rates should be lower.

 

BONUS Answers!

A) Interest rate risk is a time based risk that occurs when rates fluctuate. Since rates will change more often over a long period of time relative to a shorter period, there is a premium added to account for the risk. This is one of the reasons the 10-year treasury has a higher return than a 6-month treasury. Homeowners at one time had to pay a penalty if they paid off their mortgage early.

B) Any person or organization that invests in the long-term faces the chance that interest rates will change. Insurance companies, pensions, and many investors who purchase bonds encounter similar patterns of risk.  

You might also like Meet the New Economy, and The Fed and Monetary Policy - Where do we go from here?