Question

How would a significant increase in excess cash (actual cash minus required cash) impact the measure of the firm’s Free Cash Flow?

Answer 1

Ans : A Cash is something companies like to have but, a proper balance of the same is a must for the firm to be managed properly. Many things contribute to the reasons behind a firm’s cash position. At first , it makes sense for investors to seek out companies with plenty of cash on the balance sheet but on the other hand it reflects the utilization of the capital being utilized properly or not i.e. the investors are getting a proper return on the amount being invested as the idle cash is a part of their capital or a part of a return on he capital and it shows how efficient the management is in utilizing the excess cash. A amount of cash use to varies with the firm business and it will have the following impact on them

1)Excess cash for the firm is better: A excess cash reserve typically signals strong firm performance. Highly successful firms in sectors like software , services, entertainment, and media do not have the same levels of spending required by capital-intensive companies. So their cash builds up.As compare to companies with a lot of capital expenditures, like steel producers, must invest in equipment and inventory that must be regularly replaced. Capital-intensive firms have a much harder time maintaining cash reserves and apart from it the firms in cyclical industries, like manufacturing of seasonal products like winter clothes ,agriculture processing unit etc have to keep cash reserves to ride out cyclical downturns. These companies need to stockpile cash well in excess of what they need in the short term. The firm with excess cash flow needs to make sure that they are making a proper balance of their cash so as to increase there return from it and enhancing the profitability of the firm.

2)Excess cash of the firm is not good: High levels of cash on the balance sheet can risk to the firm in future. If cash is more frequent feature of the company's balance sheet, the shareholder as well as the lenders will have a cause of concern over the cash is not being put to use. Cash could be the cause of inefficient management as they are not able to see further area of investment and losing a opportunity of increasing the return for the shareholders .Sitting on excess cash will be an expensive luxury because it has an opportunity cost, which amounts to the difference between the interest earned on holding cash and price paid for having the cash as measured by the company's cost of capital. If a firm can get a 15% return on equity investing in a new project or by expanding the business rather than a 10 % existing return on capital, it will be more appropriate for the firm management to invest the same and increase the return for the shareholders. If the project's return is less than the company's cost of capital, the cash should be returned to shareholders in the form of dividends in turn will increase the shareholders returns on share capital and wealth.

Conclusion : A firm need to maintain a proper balance between the cash it holds and the returns it can generate by identifying and utilizing it cash efficiently for the business and reducing the cost of capital to the firm and increasing the return on the same.