One of the responsibilities of the CFO is to decide what to do with the cash flowing in. Presumably he or she is sufficiently lucky that disposition of cash is the worry instead of staving off Chapter 11. What do companies do with their cash? It seems obvious but it is actually an interesting question and the answer goes some way towards addressing how the economy works, more particularly why certain business phenomena come in waves.
First of all the CFO pays his bills like the rest of us. The first tab that the operating divisions will leave him to pick up is interest on the company’s debt. After that he pays the tax bill on what is left – typically around 34% – 36%. What remains is net income after tax, but he also has the cash that came from the divisions in the form of depreciation, which isn’t taxable profit of the company. The next claim on the pot is debt repayment. A balance sheet will show as short-term or current debt, the proportion of the long-term debt that becomes due in the current year, so he knows what he has to pay. Having satisfied the external claims he starts to look internally. First of all, he looks at capital spending. No company can live indefinitely off depreciation, without eventually rebuilding its capital stock. This will have been budgeted in advance, often as a percentage of revenue so he has a good idea what needs to be put aside for capex. If the company is expanding capacity capex will likely be a bit more than the depreciation inflow, so he is now down to some level a little below his income after tax. If the company is growing rapidly he probably has to fund an increase in working capital, to cover larger receivables and inventory.
Now he, his CEO and the board have some tricky decisions. How much should they distribute to shareholders? Some companies with very rapid growth records have never issued a dividend, while others have a long history of distributions to shareholders. If there is a historic pattern of dividends the company would be wise to continue this, as markets get excited and upset by dividend reductions. Let’s say the CFO is directed by the board to release a modestly increased dividend, since profits are up this year.
Many companies will have issued shares to fund options and will use cash to buy back the equivalent amount to avoid dilution. The CFO might wish to pay down the company’s debt ahead of the payment schedule if the debt-to-equity ratio is a bit high. Often getting debt down from high levels supports the stock price. However, let’s assume this isn’t the case, and that there is now a few hundred million in cash left over.
Our trusty CFO has run out of good ideas for using cash, and moves seamlessly on to the remaining options, all of which are, to varying degrees, bad.
One idea is to repurchase additional stock to try to send a signal to the market that the board thinks the stock is undervalued. I discussed this recently in somewhat unenthusiastic terms. It has the downside of revealing that he hasn’t any better uses for the money. He might simply elect to keep the cash on deposit, but there will surely be moaning at the next AGM from some local college professor who sees this as a sign of “lack of imagination” or “poor investment practices” on the part of the company. He considers calling up the division heads and asking them to spend more money on capital (which they will usually do without a murmur), or even more on R&D. The problem is that he isn’t sure that there will be the same surplus next year and he doesn’t want to have to commit to patterns of spending for a long period. Many big capex projects take years to complete. R&D costs would be charged against next year’s operating income, so that isn’t so good. Better not to say anything, especially since he gave everyone a really tough time over their capital budgets this year, and he would look foolish asking them to let rip at this stage. He could always buy some other company’s stock or corporate bonds and get a better yield than a deposit rate. The problem is that anything he buys could equally well go down in value and then there will be hell to pay. He is starting to realize that a company doesn’t have too many good places to park its cash.
After a few weeks of earnest thought, our CFO comes to a decision. One Monday morning he walks into the CEO’s office and says “You know, maybe this is the right time to make an acquisition.” Suddenly, his problem is solved.
