You might have heard the phrase ‘Cash is the king’.

A cash-rich business means that the company has enough cash left after paying all its expenses and debts. For the company with high cash, it simply means more liquidity and opportunities for the business.

However, very high cash is also not good for a company as it means that the company is leaving potential investment opportunities. Overall, low cash can affect business stability and high cash can reduce its efficiency.

And therefore, it is really crucial to understand the cash position of business before investing. In this post, we are going to discuss how to evaluate the cash-rich businesses to understand whether the company has low, sufficient or excess cash.

Cash and cash equivalents

When it comes to evaluating the cash position of a company, the investors look into the cash and cash equivalents (CCE) section of the balance sheet.

These are the company’s assets that are cash or can be converted into cash fast. Here, cash equivalents can be defined as the assets that can be converted into cash within 3 months like Money market funds, Short-term Government bonds, Treasury bills, Marketable securities etc.

All cash and cash equivalents are recorded in current assets segment of the balance sheet and are the most liquid asset of a company. Now, let’s understand the two common scenarios with respect to the cash level of a business.

Case 1: Low cash

When a business has low cash, it can be little worrisome for the company as it may have or will face some problems to pay short-term obligations.

In case of sufficient cash, companies can easily settle short-term debts (obligations), make an in-time purchase of new inventories/equipment, buy into lucrative investments/new technology, grab mergers and acquisition opportunities, increase dividends etc.

However, lack of adequate cash may push the company towards potential short-term problems. As a thumb rule, avoid investing in companies with low cash balance.

Case 2: High Cash

Although high cash helps a company in staying out of trouble of short-term obligations, supporting regular business operations in tough times, funding in its growth, superior performance etc. However, many times, excess cash be a little unfavorable.

Too much cash in company’s balance sheet simply means that the company is leaving potential investment opportunities to invest in the growth of its business operations or investments in other higher return instruments.

As Warren Buffett used to say- “Cash is the king. But it’s not much help if the king just sits there and does nothing.”

Too much cash reflects the inefficiency of the management to utilize it properly.

How to evaluate the cash of a business?

The cash position of a company can be evaluated using cash to current assets ratio. This ratio reflects the percentage of the total assets by cash and cash equivalents

Cash to current assets ratio = (Cash and cash equivalents)/(Current assets)

Although ideal cash and cash equivalents depend highly on the industry, however, as a thumb rule, cash to assets ratio of more than 40% can be considered to be excessive cash for the company.

Now, let us calculate the cash to current assets ratio of Hindustan Unilever (HUL) from its balance sheet.

(Source: Yahoo finance)

From the above statement, you can find the cash and cash equivalents (CCE) and total current assets of HUL over the years. For the year ending March 2018, the cash to current assets ratio turns out to be equal to 5.57%, which can be considered decent. (Quick note: You need to check this ratio over the past few years and compare with the competitors to better understand the cash position of HUL).

Also read:

• How to read the financial statements of a company?
• #19 Most Important Financial Ratios for Investors
• What is Free Cash Flow (FCF)? Explained in Just 1,000 Words.

A word of caution:

Although having high cash is good for businesses, but it is equally important to understand the source of that cash i.e. where that cash is coming from?

There are different ways for a company to pile up cash. Apart from the profitability of the business operations, a few other ways to build cash is by taking debt or selling its assets. And both of the later two ways to generate cash is not favorable for a company as a high debt means greater interest obligations. Further, selling the assets to pile up cash may affect the future profitability of the company.

Therefore, you should always check the source of cash for the cash-rich businesses. You can find out this by looking at the cash-flow statement of a company.

In the cash flow statement, check the cash from operating activities. If this is consistently increasing, it’s a positive sign and means that the company is able to generate profits from its core businesses operations. Further, also check the cash from investing activities to find out purchase or sale of assets. Finally, also look into the debt obligations of the company for the long-term and find out its trend over years.

Note: If you are new to the financial world and want to learn how to effectively read the financial statements of companies, feel free to check out this awesome online course on Introduction to Financial Statements & Ratio Analysis.

Bottom line

The cash of a business can be roughly evaluated by navigating the cash and cash equivalent section in the company’s balance sheet. Here, cash to current assets ratio is used to check the cash level of a company.

A company should have sufficient cash to effectively run its short-term operations. However, huge cash can also be little troublesome for a company as it reflects the management’s inefficiency to use the cash productively.

That’s all. I hope this post is useful to you. Happy Investing!!

Kritesh Abhishek

Kritesh (Tweet here) is the Founder & CEO of Trade Brains & FinGrad. He is an NSE Certified Equity Fundamental Analyst with +7 Years of Experience in Share Market Investing. Kritesh frequently writes about Share Market Investing and IPOs and publishes his personal insights on the market.