It has been said that companies are better off returning their excess cash to stockholders if there are no value-creating opportunities to invest in.
When companies cannot earn their opportunity costs, returning unused cash in the form of dividends or stock buybacks can help preserve shareholder value.
But given the uncertainty in the current economic climate, as COVID-19 pandemic continues to disrupt businesses, companies also need to stay liquid.
By retaining a portion of their earnings, companies can build up their cash reserves to cover unexpected costs and unplanned payments.
So, how do we know if a company is retaining too much or too little cash in this time of crisis?
We can do this by estimating a company’s free cash flow from earnings after meeting all its reinvestment needs.
Using the cash flow statement, we can get a company’s capital expenditures, net of depreciation charges and working capital needs and subtract it from its net income.
Because we are measuring the cash flow effects to equity, we shall also consider the changes in debt balances.
If a company availed more loans to partly finance its capital expenditures, we shall add the net proceeds to the free cash flow, and if a company repaid more debts, the net payments shall be deducted from it.
Once all the adjustments are made, we shall compare the resulting available cash from earnings called free cash flow to equity (FCFE) to the total cash paid out to stockholders.
If the ratio of total cash payout to FCFE is less than 1, it means that the company is paying less than what it can afford, and is reinvesting the balance to strengthen its cash position.
On the other hand, if the ratio is over 1, it means the company is paying out more than it can generate by drawing on its existing cash balance.
For example, in 2019, when Emperador returned its excess cash in the form of dividends and buybacks to stockholders, its cash payout ratio based on earnings was only 24 percent.
But if we compare the total cash paid out against its FCFE, the ratio was at 1.03, which was more than the available cash flows of the company.
Although total payouts were budgeted well within its net income, the remaining free cash flows, after meeting all capital expenditures and debt payments, required the company to finance its deficit using their cash reserves.
In 2020, the following year, when Emperador’s net income increased despite the pandemic outbreak, the company doubled its total budget for dividends and buybacks at 52 percent of its 12-month trailing net income.
This time, however, instead of reinvesting, it cut down its capital expenditures by 66 percent to repay its debt and increase its liquidity position.
With higher cash flows, the total cash paid out of Emperador represented 69 percent of its FCFE, or ratio of less than 1, which means the company used the balance of 21 percent to reinforce its cash position.
This trend in corporate saving also mirrored a similar pattern among companies belonging to the Philippine Stock Exchange index (PSEi).
The average cash payout of PSEi companies, as percentage of FCFE, has been declining for the past two years. From a high of 33 percent in 2018, the cash payout ratios have fallen to 16.7 percent in 2019 and 10.1 percent in 2020.
The decrease in cash payout ratios was due to the slowdown in earnings and capital expenditure growth, which caused average FCFE to decline by 40 percent.
Lower cash payout means higher cash reserves, which went up by 9 percent last year, as companies build up their liquidity buffers for the economic turbulence ahead.
As risk rises with resurgence of coronavirus cases with higher inflation and interest rates, companies are likely to play defensive by deleveraging and reducing their capital expenditures going forward.
While rising cash balances are signs of a company’s financial strength, especially in time of uncertainty, increasing excess cash are also reflections of lower growth and declining returns in the months to come.
Henry Ong is a registered financial planner of RFP Philippines. Stock data and tools provided by First Metro Securities. To learn more about investment planning, attend 89th batch of RFP Program this May 2021. To register, e-mail info@rfp.ph or text at 09176248110