What should businesses do with the extra cash?

Today, some companies have a lot of cash. Holding cash doesn’t sound wise in an inflationary environment, but it does sound wise in a recession. Let’s break down the options for a typical business and the pros and cons of each. For this purpose, “cash” refers to bank accounts, money market funds, Treasury bills, and other short-term liquid assets.

The context for the discussion is late 2022, when many economists, including myself, are predicting a recession. Despite some layoff announcements, most companies can’t find as many employees as they want. Supply chain challenges have eased, but remain above normal in many industries. Interest rates are rising, significantly improving cash returns compared to last year.

Broadly, the options are to hold cash, pay down debt, buy inventory, buy assets, or pay dividends to owners.

Holding cash is always a good option, but not always the best option. The benefit of it is that it presents options for the future, which may include any of the other possibilities discussed below, but the decision is delayed. Holding cash has little downside risk and allows you to capture possible future upside opportunities. With inflation, the purchasing power of cash will decrease over time, but at least the dollar value of the asset will not decrease.

And today — unlike years past — the cash pays off. As long as the U.S. doesn’t completely collapse, three-month Treasury bills are risk-free, paying a little over four percent in interest, as are commercial paper. Smaller companies can find attractive CD rates.

The second option is for the business to pay off its debt. In most cases, interest rates on bank loans are higher than those on cash. However, there is a big strategic difference between repaying a line of credit and paying off term debt early. Paying down a line of credit saves on interest charges and preserves the ability to use that line in the future. Banks often view a payment as a sign of financial strength. Just as cash provides options for the future, so does a line of credit.

Repaying a term loan is different. On many business loans, there will be a prepayment fee. And the same monthly payments are often required, so if the business needs cash after a few months, it’s a hassle. In most cases, a better plan is to put the cash used to repay the loan into an interest-bearing account. The spread between interest expense and interest earned is negative for the company, but that makes up for the flexibility of having cash on hand should circumstances change.

Buying more inventory is an option you might not have considered a few years ago. This can be a poor choice if the company sells items that are quickly out of date, seasonal, or at risk of being stolen. However, consider the example of a nut and bolt dealer. Fasteners will eventually be sold. Companies are protected from supply disruptions. For manufacturers, building up inventories of finished goods prevents factories from closing due to sick workers. Inventory shouldn’t increase too much, but a little more could be a good use of cash.

Property purchases can also be considered. They can be stationary equipment such as computers, trucks, or machinery. Or the asset might be another company. Or real estate that will eventually be used for expansion. The current tight labor market advocates the use of equipment to replace workers who cannot be hired. The downside is that, once spent, that cash can’t be used to weather a recession. Therefore, cash flow forecasts under recession forecasts should precede large capital purchases. At this point, most of the equipment a company would consider is on backorder because other companies are thinking the same way. When we enter a recession, there may be better deals and the labor market may ease — but only temporarily.

Buying another company, such as a competitor or expanding a geographic footprint, always carries risks, but is sometimes a good option. Make sure the valuation includes a possible downturn, not just looking back at recent profits. As with capital expenditures, make cash flow forecasts in advance.

The best deals tend to come during or immediately after a recession. Therefore, companies seeking acquisitions should wait patiently until more serious pain hits potential targets. However, if an opportunity arises, say due to the death or retirement of another business owner, the ability to act quickly may be a purchase at a reasonable price.

Finally, cash payments to owners as dividends are a possibility. From a narrow perspective of business, this is a poor choice. But entrepreneurship is not started as a business; funds are invested by the owners to earn a return on investment. If the owner wants a dividend, there is little argument with them. (If the dividend might impair your ability to pay your debts, then consult an attorney first.) Sometimes the owner of a closed business needs a large dividend from one company to keep the other afloat. This is a reasonable choice. Still, if management teams make their decision, they should remember that cash offers a lot of flexibility to ride out tough times and capitalize on future opportunities.

Cash is good because some uses of cash are good. Sometimes it is better to seize these opportunities now than to wait forever for better ones. But sometimes not.

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