Cash is King

No doubt if you have been following the stock market, you have heard that cash is accumulating on the balance sheets of companies. However, “Cash” is not the same as cash accumulating in your bank account.  “Cash” in accounting terms is simply a line item in the asset column.  It’s a placeholder for a credit entry.

“Cash flow” is something else.  That is the money that flows through the company and provides the grease for operations.  Cash flow is what Chief Financial Officers of companies are really interested in.

Just because we are in a recession, doesn’t mean companies don’t execute business.  Since the recession has started, companies have girded themselves.  How have they done it?  First, the stopped investing in any capital projects that would expand their operating costs and balance sheet.  Second, they factored in the detrimental effects of the expansion of government via Obamacare, the effects of higher tax rates, and the effects of an aggressive regulatory environment.  Third, instead of borrowing and increasing leverage, they paid down debt.

But they have to be careful about paying down too much debt.  A proper debt/equity ratio is good for running a business.   If the level of debt dips too much, then the business will be faced with much higher tax bills.  Whenever the economy takes off, the business will have to grow from cash or equity when it’s generally cheaper to grow via debt.  Debt isn’t necessarily a four letter word in business.

As cash builds, CFO’s are under great pressure to do something with it.  Merger and acquisition activity has started to heat up.  Some deals will get done simply because the price of the company is reduced when it carries a hefty cash balance. However, companies have to be very mindful of how big they get.  Not only are they facing the wrath of far left wing regulators, but bigger companies are significantly harder to manage.  Much harder to turn an aircraft carrier around than a PT boat.  If we have learned anything in the crisis, sometimes it pays to be a PT boat!

Once the M+A picture clears and a CFO is still left with cash on hand, they have two choices.  First, issue a dividend to shareholders.  Second, buyback stock.  Dividends to shareholders are not appreciated by a lot of shareholders, especially large mutual funds.  Big special dividends create tax problems for them.  Buybacks however don’t reward the long term shareholders.  If a company is buying back stock, it shows that business prospects are dismal.  Buybacks only enrich investment bankers and stock scalpers.

Today, more and more CFO’s are buying back stock.  This is not a positive long term signal for “the bull”.  They also are making a decision to recognize revenue this year rather than next.  Next year, I wouldn’t look for as robust earnings.  Not a good sign for “the bull”.  There is a good reason hedge funds haven’t participated in this rally.