Equity market: Should excess cash holdings worry shareholders?

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To conclude, investors need not worry about the increasing trend of cash holdings as cash is being conserved for the possible growth opportunities in the near future.

By P Saravanan and Swechha Chada

In A STUDY on dividend and buy-back, Institutional Investor Advisory Services reported that India companies, predominantly non-financial firms, were holding over Rs 880 billion in cash and cash equivalent, at the end of FY 19-20. This is almost 4.4 times higher compared to the cash holdings in 2016.

Why there is a sudden surge in cash holdings among Indian firms in spite of increased pay-out to their shareholders is an interesting question for shareholders. Let us discuss the same in detail and assess whether investors should worry about it.

Why do firms hold cash?
Often people say that cash is king and it is the life blood of the business. In the corporate environment, a large part of cash is generally held in the form of marketable securities, government bonds and short term investments. Firms hold cash for a variety of reasons.

First, the firm saves transaction costs to raise funds and protect themselves from future liquidity needs. It is called transactionary motive. The firm can use the liquid assets to finance its activities and investments if other sources of funding are not available or are very costly. The firm need not worry about the credit market conditions as long as it has sufficient cash and this is known as precautionary motives. Often, cash is used to protect the firm from hostile takeovers and to maintain the firm’s market share. Excess cash could be used for buy-back, pay out dividends, acquisitions, etc.

Who holds and how much?
Generally, IT and pharma sectors have higher cash as a precautionary motive. These firms hold cash as they may need to make investments in companies with specialised skills or technologies. Companies in a few sectors like automobiles are waiting to spend cash on capital expansions. Higher cash holdings by firms also send signals that they have less growth and investment opportunities.

An analysis of the cash holding pattern of BSE listed firms reveals that the IT sector is holding large amounts of cash, even after returning cash to the shareholders in the form of dividends and increasing buybacks. This is followed by FMCG, pharma and health care, automobile, and chemical manufacturing. Small cap firms are holding around 7.3% of their total assets in the form of cash and cash equivalents whereas large cap firms are holding around 5.9%.

Financial constraints lead to cash holdings
Generally, a firm is considered as financially constrained, when the internally generated cash is not sufficient to meet the capital expenditures, expansion plans, etc., and external funds are costly. Firms accumulate cash to avoid passing up profitable investment opportunities, by saving cash from cash flows in good economic cycles, to be used when the cash outflow/expenses are higher.

This retained cash allows the firm to rapidly exploit growth opportunities. Further, firms who have higher volatility in cash flow such as electrical, machinery and transport sectors, chemical and pharmaceuticals tend to have higher cash holding and at the same time reduce their pay-out as dividend to shareholders. Volatility in cash flow is perceived as a firm’s business risk, and increases the cost of capital. Financially constrained firms and firms with high debt equity ratio tend to have higher cash holdings.

Should investors worry?
Excess cash holding leads to low share value as the company is not effectively using the cash available with them. Investors might fear the expropriation of cash by the promoters or investment in less profitable ventures and therefore investors demand more dividend pay-outs. To conclude, investors need not worry about the increasing trend of cash holdings as cash is being conserved for the possible growth opportunities in the near future.

P Saravanan is a professor of finance and Swechha Chada is a doctoral scholar in finance, IIM Tiruchirappalli

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