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What to Do With Your Excess Cash

Digital Library > Acquiring and Managing Finances > Cash management “What to Do With Your Excess Cash”

Having too much cash on hand hardly seems like a problem. But unless you know how to evaluate the portfolio of possible projects, you may choose poorly.

OVERVIEW [top]

As the economy has flourished over the past several years, many businesses have seen sales grow dramatically — in many cases, tripling and even quadrupling.

Getting the most out of excess cash requires shrewd decisions about how to invest it.

In this Quick-Read you will find:

  • How to decide where to reinvest your excess cash.

SOLUTION [top]

When a business generates excess cash, the decision about how to best use that cash will often determine the future success of the business. While the entrepreneur may be inclined to take the money as salary or a bonus, often the more prudent choice is to carefully reinvest the funds to help propel growth.

Your first step should be to project your daily and emergency cash needs for the next year. What was your minimum cash balance last year? If you haven’t recorded the daily balance reports from your bank, find the lowest balance reported on the monthly statements. Is that excess cash a temporary occurrence, or is your company going through a boom that will last a while? If you anticipate needing cash within the next year, park your money in Certificates of Deposit with maturity dates timed to free the cash as it is needed. If CDs are not reasonable because the timing of need for cash cannot be predicted, at least move the available cash from your savings account to a money market account to earn more interest.

Otherwise consider investing in projects that will help your company grow into the future.

Using net present value analysis to evaluate projects

To help you decide among multiple projects you need to become familiar with a common financial tool called net present value (NPV) analysis, which is available with most spreadsheet programs. If you have not been using a spreadsheet, such as Excel, Lotus or Quattro Pro, now is the time to start. The return on your investment in the software and the time it takes to learn and use it will include better financial decisions and much more confidence in your control of resources.

Your financial adviser can show you how to use NPV analysis to evaluate projects, but the basic idea is to compare the expected investment and return on each project to see which one is most profitable. Because each project will have different investment and return time horizons, the NPV tool lets you compare each project in real dollars (taking inflation and the cost of capital into account). You may find that of all the projects available to you, your best investment is the stock market or a money market fund. Such knowledge can save you a lot of time and frustration.

For example, let’s look at three investment options. We will disregard inflation because it will affect all three options equally.

  1. A money market fund. When mmf interest rates are 5% to 6%, the long-term return is only half that of the stock market.
  2. Investment in equipment. Scenario: The equipment costs $100,000 and you expect that it will return an extra $20,000/year to your bottom line over the next 13 years (plus an extra $20,000 return for tax deductions for depreciation during the first four years). After 13 years the machine will wear out and need replacement.

    Assuming it would cost you 10% to borrow money for the project (your cost of capital or discount rate), the NPV calculation would produce a net present value of this project at $52,651. In other words, you recoup the $100,000 investment plus $53,000. (*note – you can also think of cost of capital as the opportunity cost of using this money. If you invested in the stock market, you could earn 10% on average. Your investment in the equipment, therefore, had better earn more than a 10% return. In this case it does.)

  3. Investment in marketing. Scenario: It costs $500,000 to buy a small three-person marketing company so that you can start handling your marketing in-house.

    You previously spent $100,000/year outsourcing your marketing, and now you will have additional employees and costs for marketing at $250,000/year. But you expect your sales to increase by $200,000 year. The net result is an increase of $50,000 per year. How does this project compare to the above project?

    The NPV calculator in Excel reveals that the net present value of this project is negative ($131,665) over a 13 year period. Assuming a 10% cost of capital (discount rate), this would be a poor choice for an investment.

By evaluating all of your investment options using this tool, you can find out whether you would better off investing in one project over another or if your best choice is to put your money in the stock market and earn an average of 10% interest. Market conditions may change after a few years revealing projects that will deliver a return of better than 10%.

So to get started, list the various projects and investments that you have available to your business. Then identify the following for each project:

  1. The initial investment.
  2. The ongoing (working) costs.
  3. The expected return.

It is fairly typical to use a 10% discount rate (or cost of capital). We used 13 years in our example, but you can use seven or 10 years if that seems more reasonable for your business. In the purchasing equipment example we could have used a seven-year time horizon and then estimated the amount we could resell the machine for at the end of seven years. That would be added into the calculation and discounted just like the revenue.

If you know how to calculate net present value, create the tables and do your comparison. You can review the method in the Quick-Read “How to Create a Budget.” Otherwise seek help from an accounting professional. You don’t want to make a wrong calculation and end up making the wrong decision.

This process will help give you confidence in your choices of where to park your cash to give your company the best possible chance of success in the future.

Other investment options

Look into investing in things related to your business. You could:

  • Purchase the factory your organization needs to produce its widgets.
  • Buy out one of your suppliers and begin to vertically integrate your supply chain.
  • Buy out a distributor and gain better access to your end users.
  • Retire debt.
  • Develop a new product or service.
  • Pursue a new market.
  • Open other new marketing channels, e.g., telemarketing, Internet sales.
  • Start a subsidiary operation.

Don’t limit the operations you consider to those covered by cash on hand. It can be supplemented by borrowing.

Investing company funds in noncompany-related investments

In this era of get-rich-quick schemes and hot stock tips, entrepreneurs are continually tempted to put their hard-earned money into questionable investments. On hearing that a friend, relative or business associate has “made a killing,” entrepreneurs will feel pressured to play catch up. Unfortunately, the results can be catastrophic even if such opportunities are carefully investigated. You know your company better than any other business so investing in your own company gives you the most control over your return on investment.

REAL-LIFE EXAMPLE [top]

Since it opened in 1995, Caf&eacu te; Luna, a seasonal Italian restaurant in Cape Jeffries, N.C., has grown from six to 150 seats and from $150,000 to $750,000 in annual sales. Every fall, when the restaurant closes its doors until the following May, owner Alan Fox finds himself with several months of free time and lots of money on hand.

In the past, he kept a cash reserve of $150,000 in a zero to 1% yielding checking account, bought stocks on hot tips (losing an average of 20% each year), and spent money frivolously. Two years ago, a friend suggested Fox attend a financial seminar to learn how to handle his money during the off-months. The two and a half-hour session convinced Fox that he needed to sit down with a professional and find ways to make his money work for him and his business.

Together, they decided to put the equivalent of three months of business expenses into a high-yield cash management account for opportunities and emergencies. A portion of Fox’s money is in certificates of deposit, while another portion is in stock market certificates. Then they used the NPV calculation to determine whether to add a wing on to the restaurant or purchase a local catering service.

As a result, Fox’s cash is now earning an average interest rate of 6.8%; his investments averaged 38% last year; and he and his business saved an additional $30,000 in taxes last year. He also decided to add on the wing to his restaurant because the NPV calculation produced a positive return of $40,000 over five years versus only $5,000 for the catering business.

DO IT [top]

  1. If you have extra cash, consider yourself lucky. Then evaluate how best to use that cash. Are you going to invest it back in the business or cash out?
  2. Enlist the assistance of a financial professional. Don’t try to be a jack-of-all-trades. A financial professional can help you make intelligent decisions based on the financial numbers. You can then be more confident in your decisions.
  3. If you plan to invest in securities, do some homework first. Get investment guides from the library or bookstore, and learn about the risks and potential benefits of various types of stocks, bonds, and mutual funds.
  4. Learn how to do an NPV calculation. Once you know how to do this, you can use this tool to analyze and compare a variety of projects.
  5. Establish a line of credit at your bank. Having quick access to short-term loans allows you to maintain a smaller year-round account balance and put more cash to work.
  6. Ask your banker about options for getting daily cash receipts into the most lucrative accounts as quickly as possible and options for minimizing the cash balance in non-interest-bearing accounts.
  7. Check every year or two to confirm what bank charges you are paying, and see if any competitor of your bank offers a better deal.
  8. Consider donating some money to charity. See the Quick-Read “Corporate Philanthropy: Why and How.”

RESOURCES [top]

Books

Cash Flow: A Practical Guide for the Entrepreneur by Bill Meyer (Perc, 1998).

Financial Planning for the Entrepreneur by Donald E. Vaughn (PrenticeHall, 1997).

Articles

“Why Not Leverage Your Company to the Hilt?” by Amar V. Bhide, Harvard Business Review, May-June 1998. Bhide argues that your cash on hand is as wasteful as stock inventory sitting idle; and if you can borrow money at 10%, deduct that interest, and invest the money for a 10%+ return, you should. There is a $6.50 charge to view the article.

“Art of Cash Management” by Jill Andresky Fraser, Inc., October 1998.

Article Contributors

Writers: Eric Vines and Richard Blue

Interview with Jay Trien, president, Venture Association of New Jersey, and senior partner, Trien Rosenberg, Marstown, N.J. (973) 267-4200.

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