When making long-term investments, investors consider a variety of factors. One of the most important is the financial situation in a particular company. And here everything is not as simple as it might seem.
At first glance, it is obvious that you need to invest in companies that have a large amount of money and few debts. It is clear that the development of borrowed funds is good with a positive development of the situation, and during crises it can lead to problems. So with free money there are pros and cons (even though it is hard to believe in the current crisis).
Portal Investopedia published material with an analysis of this situation. We publish the main points of this article.
Why is company extra money good?
There are a number of factors. First of all, the presence of serious and growing stocks of money indicates the quality work of the company. It turns out that the business earns so much and so quickly that the management does not have enough time to distribute the money and understand what to spend it on.
In addition, there are entire industries, such as software development, where such large-scale capital costs are not required to conduct a business. If the company makes good money at the same time, it is absolutely logical that it has free money left.
In other industries, such as the steel industry, players are forced to constantly invest in equipment and materials, so it is physically more difficult for them to save money. Also in industries with cyclical demand, companies stockpile money in the high season, in order to then survive the impending recession.
As you can see, in the presence or absence of cash reserves may be due to various reasons.
When a lot of money is bad
A large amount of free funds on the balance sheet of a company may be a sign of future problems. If the company constantly has a lot of free money, and this amount does not change much, investors should ask the question – why are these funds not invested in development?
Perhaps the company’s management is aware of certain problems that will not allow it to attract investments or loans, or the managers simply do not have enough experience and competencies to figure out how to effectively spend the money.
“Sit on the cache” for the company – an expensive pleasure, because it misses opportunities for development. You can evaluate the loss as the difference between the percentage of money in the bank and cost of capital.
If a company can expect to receive a 20% return on investment in a new project, then this is much more profitable than just storing money in a bank. If the return on investment is less than a bank deposit, the company can pay dividends to shareholders. In any case, just having a lot of money is not very logical.
In addition, quite often companies with large stocks of money run the risk of losing in management efficiency. When there is a lot of money, it is more difficult to build a clear financial discipline, to limit costs, it is easier for management not to fulfill the declared KPIs. To better understand such situations, you should regularly read analytical materials in selected industries.
How companies disguise surplus money
Investors should not be fooled by the usual excuses that free money gives the company the flexibility and ability to take over. The presence of a large amount of money in stocks has its price and provokes inefficient management.
Therefore, you should be wary of seeing items called “strategic reserves” and “reserves for restructuring” in the financial statements – this is often just a justification for excessive savings.
Extra money for a company is not always bad. However, it is important to be able to distinguish situations where it is really useful, from cases in which large reserves generate future losses and indicate poor corporate governance.
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