US Dollars (Photo by Chung Sung-Jun/Getty Images)
Some companies have a lot of cash these days. It doesn't seem wise to hold cash in an inflationary environment, but it does seem wise to hold cash for a recession. Let's catalog the options a typical business has, along with their pros and cons. And for this purpose, “cash” refers to bank accounts, money market funds, Treasury bills, and other short-term liquid assets.
The background of the discussion is the second half of 2022, when many economists, including myself, are predicting a recession. Despite some layoff announcements, most companies are unable to find as many workers as they would like. Supply chain challenges have eased but remain above normal in many industries. And interest rates are rising, making returns on cash much better than last year.
Broadly speaking, your options are to hold on to cash, pay off debt, buy inventory, buy assets, or pay dividends to owners.
While holding on to cash is always a good choice, it's not always the best choice. This is great in that it provides future options and may include other possibilities discussed below, but it delays the decision. By holding cash, there is less downside risk and it is possible to seize upside opportunities that may arise in the future. Inflation reduces the purchasing power of cash over time, but at least it does not reduce the dollar value of assets.
And today, unlike in past years, cash generates profits. Three-month government bonds, which are risk-free unless the U.S. completely collapses, pay an interest rate of just over 4%, similar to commercial paper. Small businesses can find attractive CD interest rates.
The second option is for the company to pay down its debt. In most cases, the interest rate on bank loans is higher than the interest rate you can get on cash. However, there is a big strategic difference between paying down a line of credit and paying off term debt early. Paying down a line of credit saves you interest costs and preserves your ability to draw on that line in the future. Banks typically view repaying a line of credit as a sign of financial strength. Just as cash provides options for your future, a line of credit provides the same options.
Term loan repayments vary. Many business loans have prepayment fees. They also typically require the same monthly payments, which can make it difficult to run a business if you need cash a few months later. In most cases, a better plan is to keep the cash for loan repayments in an interest-bearing account. Although the spread between interest paid and interest received is negative for the company, it compensates for the flexibility of having cash on hand if circumstances change.
Increasing inventory is an option that would have been unthinkable a few years ago. It's probably not a good choice for companies that sell products that go out of style, are seasonal, or can be stolen. But consider a nut and bolt vendor. The fasteners will be sold eventually. The company is protected from supply disruptions. For manufacturers, increasing inventories of finished goods protects against factory closures due to employee illness. You shouldn't increase your inventory dramatically, but increasing it a little may be a good use of cash.
Purchase of assets may also be considered. It could be capital equipment such as computers, trucks, machinery, etc. Alternatively, the asset could be another company. Or real estate that will eventually be used for expansion. Due to the current tight labor market, there is discussion of using equipment to replace unemployable workers. The downside is that once you spend it, you can't use that cash to ride out a recession. Therefore, cash flow forecasts based on recession forecasts should be made prior to large capital purchases. At the moment, other companies are thinking the same way, so much of the equipment companies are considering is on backorder. As we enter a recession, better deals may become available and the labor market may ease as well, but it will only be temporary.
Acquiring another company, such as a competitor, or expanding your geographic footprint always involves risk, but in some cases it can be a good choice. Don't just look retrospectively at recent profits, but make sure you evaluate them for the possibility of a downturn. As with any capital investment, perform cash flow forecasts in advance.
The best deals tend to be available during or just after a recession. Therefore, companies considering acquisitions must be patient until more severe pain hits a potential target. However, if an opportunity arises, such as when another business owner dies or retires, you can act quickly and potentially get a good price.
Finally, there is the possibility of paying cash as dividends to the owners. From a narrow business perspective, that is a bad choice. But a business does not start simply to be a business. Money is invested by the owners to get a return on investment. There is little debate if the owners want dividends. (If dividends might cripple your ability to pay your debts, consult with an attorney first.) The owners of a closely held business may need a large dividend from one company to sustain another. That is a rational choice. But management, if they make the decision, should remember that cash provides great flexibility to weather tough times and take advantage of future opportunities.
Cash is good because there are good things you can do with it, and sometimes it's better to grab a better opportunity now than to wait forever for one. But sometimes it's not.
