Financially savvy: Cash is king, so is cash ratio sometimes

Cash is one of the more important metrics for investors to examine before investing in companies. The level of cash usually relates to the investment safety of companies, where the higher the amount of cash, the safer the investment. This is mainly because having more cash allows the company to do a variety of different things such as expanding its business and paying dividends. But most importantly, it acts as an insurance and financial cushion during rainy days.

The level of cash a company has can be found in the balance sheet or the statement of financial position. Cash is the most liquid form of asset a company can own because other assets in comparison take time to convert into an acceptable medium of exchange. For example, if a company owns property, it may take a considerable amount of time to find a buyer for the property and for the cash to be settled, or even to be able to sell it at a favourable price. Because of this, cash is the most reliable form of asset, assuming all other assets are fairly valued or not overvalued. The key point to note here is: the more liquid the asset is, the more reliable and safer the investment into the company is.

However, it is important for investors to look at cash in relative terms, not absolute terms. A company, for example, may have a few hundred million dollars in cash but a few billion dollars in debt. This company is much worse off than a company which may only have a few hundred thousand dollars in cash but no debt from an investment safety perspective. At the same time, the first company is unlikely to be able to pay dividends and would have to borrow money to pay dividends, which further exacerbates its weak financial position. The second company in this situation would have less of a need to borrow money in order to expand its business and has much more flexibility in deciding how it chooses to finance its expansion.

Since cash is what a company owns, cash is only king if it is relatively better than what the company owns. A company can utilise its cash in many different ways, and for the investor, there are a few possible areas to consider and analyse before investing. First is investment safety, which is arguably the most important. To gauge this metric, the cash ratio is suitable. The cash ratio is essentially the company’s cash and cash equivalents compared to its current liabilities. In other words, this ratio measures the liquidity and ability of the company to settle its short-term financial obligations with cash.

The higher this ratio, the safer the company is. When cash and cash equivalents equal current liabilities, the ratio is 1.0.

Another ratio to gauge the investment safety metric is the net cash per share. Net cash refers to the amount of cash and cash equivalents a company has after deducting its liabilities. As long as the amount of net cash per share exceeds the share price of the company, it is not just a very safe investment for investors, but also a good bargain. To put things into perspective, if say a company has $1.00 in net cash per share but the company is trading at $0.50, this means that even if the worst-case scenario happens where the company winds up at the current price, investors can expect to receive a 50% premium on their investment.

Table 1 shows the list of Singapore Ex

change- listed companies which have their net cash exceeding their market capitalisation. This is essentially the same as net cash per share compared to the share price. The excess cash should also inform investors that these companies could be potentially strong takeover or privatisation targets, as acquiring these companies would improve the financial position of the acquirer. Therefore, to investors, they could expect to receive a significant premium on their investments if they purchased the company before any takeover offers.

Having net cash allows the company to pay dividends to shareholders, which is a reliable form of investment return to investors. This is assuming the company is not withholding cash for expansion or M&A plans. This is key for dividend-based investors — having more cash or net cash improves the ability and capacity for the company to pay dividends, unless management has clearly stated the additional cash is reserved for other purposes. Similarly, having more cash allows the company to spend more on itself for business expansion — be it through the purchase of capital goods or M&A, which if done strategically and correctly, can make the company much more profitable.

Ideally, having more cash is only desirable if liabilities also do not increase as much. This is why having more net cash is always desirable to the investor. Since cash is an asset, and assets are what a company owns, it is important to also consider other less liquid assets for a more comprehensive analysis on the company. Investors ought to give a discount to less liquid assets based on how difficult it is to convert these assets into cash. For example, a very illiquid asset could be only valued at 60% of its stated value on the balance sheet because pragmatically-speaking, this could be the expected amount of cash the company would receive if the transaction were to be done as quickly as possible.

Hence, investors should keep a lookout for the cash levels of companies — but relative to what it owes — to make it more meaningful.