How to Invest: Cash Rich Companies

Joel Anderson |

Cash on hand and cash coming in can be two crucial considerations to any investor when considering a stock purchase. In short, liquidity is important to a company in a way that's not entirely different from a family. Having money in a savings account can provide much-needed flexibility to a family. If one or both parents get laid off, cash reserves can help ensure that the mortgage is paid, groceries can still be bought, and children's lessons can still be paid for.

What's more, in good times, a family with money in savings can react to immediate opportunities with more ease, maybe taking a vacation to Hawaii when a neighbor offers up the chance to use her time share or buying a new riding lawnmower when the model you want goes on sale. In business, the types of expenditures are different, but the concept is the same. Having cash reserves will allow a company to make it through lean times without having to sacrifice funding for research and development and other expenses, just as it will allow a company to react to opportunities to acquire new assets in a way that debt-strapped firms won't be able to.

To be sure, this doesn't mean that all companies with large cash reserves are a strong investment as plenty of companies with loads of cash are still making poor business decisions in the long run. Nor does it mean that companies with low cash reserves or high debt are always a bad investment. There can be any number of reasons why a company is low on cash, and companies still struggling to get off the ground are more likely to have low cash reserves regardless of their long-term potential. However, looking at cash on hand still makes for an important consideration when investing. Generally speaking, larger cash reserves mean lower risk and vice versa.

Cash Flow Also Important

Cash on hand alone isn't the only important factor to consider. The rate at which cash is coming in is also important. A company may opt to use cash reserves or take on debt in making a major acquisition, but this is easier to handle if that company has a steady stream of income it can rely on. Lets return to the metaphor of one's family.

Say little Suzie gets accepted to Harvard. It's a wonderful day and everyone's very proud, but the cost of tuition is way higher than the state school you had been planning for. Harvard will mean an array of new opportunities for little Suzie, but paying for it is going to seriously affect how much income your family can count on. With more money going to tuition each year, there's less remaining to spend on other expenses or opportunities that might crop up.

This brings us to Free Cash Flow. Free cash flow, typically referred to by its acronym FCF, is a company's operating income minus its capital expenditures. Basically, you take the total revenue and you subtract the operating expenses (built in costs like materials and payroll). Then you take that number (called Earnings Before Interest and Tax, or EBIT) and subtract capital expenditures, which are any one-time expenses like repairing facilities or acquiring new assets.

So, the question facing your family when thinking about Little Suzie's trip to Harvard is one of FCF. If you add the capital expenditure of tuition at Harvard to your family's balance sheet, it means that the FCF for the whole family will plummet, limiting the things that the family can do otherwise.

Now, this once again illustrates that FCF alone cannot determine the overall health and potential of a company. Most families would view it as a major opportunity to send a child to an elite university and one that would benefit the family in the long run and choose to hurt their finances in the short term to help out little Suzie.

However, that family's books are going to reflect the fact that it's operating with a lot less flexibility. Businesses are the same way.  A company with plenty of FCF has got money to burn and will be able to react to opportunities as well as save cash reserves to ride out lean times in the future.

Price Ratios

More often than not, cash reserves and FCF will be expressed in terms of P/C and P/FCF. In both cases, this involves dividing a company's share value by its cash assets per share or FCF per share. This gives someone a chance to compare the share price of the stock to its cash and FCF, which gives a sense of the company's cash situation as compared to its market value. Low P/C and P/FCF can generally be viewed as a positive, indicating that a stock is relatively cheap given its cash situation.

However, there can be a number of reasons for this, so it's always important to try to only consider values like these in broader contexts. However, companies that are hanging onto most of the cash they're bringing in and/or have large reserves of cash to draw on are generally in an enviable situation and could have a solid opportunity for growth.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to:


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