Easy credit means hard choices. The old consensus between lenders and corporate borrowers about what constitutes a prudent level of financial reserves has broken down. Today’s junk-bond financiers, merchant bankers, and “credit corporations” offer far more leverage than businesses have historically been comfortable with, and these venturesome lenders pose a difficult problem for management. Managers are certainly not responsible for protecting lenders from their own bravado. If high leverage creates shareholder value, managers are bound by duty (and the fear of corporate raiders) to take advantage of it. On the other hand, managers are responsible for protecting themselves from the kind of aggressive lenders who could turn their companies into corporate Brazils. The existing approaches to this dilemma are inadequate. Conventional credit analyses take a lender’s perspective: they help to determine how much debt a business can afford to carry rather than how much of its debt capacity a business should use. The issue of cash reserves is no less perplexing. Traditional rules insist on the value of excess cash when today, liquid investments are more an enticement to piracy than a refuge from disaster. The fact is, companies continue to base their financial policies on hoary rules and superficial analyses. They cling to the security blanket of a superior bond rating or they draw simplistic conclusions from their competitors’ debt-equity and cash-to-sales ratios. But any resemblance between sound financial policy and these kinds of traditional or imitative approaches is purely coincidental. Making its bonds a safe investment for widows and orphans may not be in a company’s best interest. And when all the companies in an industry defer to one another’s financial acumen, they turn into a herd, liable to wander at random. Financial Inventory Unused debt capacity and excess cash constitute a company’s financial inventory, the reserve it can draw on in time of need. The costs of holding excessive financial reserves can dwarf the costs of bulging physical inventories, and yet insufficient reserves can be more crippling still. Successful management of financial inventories can mean as much for a company’s bottom line as the introduction of JIT. Unfortunately, there is no mechanical formula or software package a CFO can use to replace the arbitrary ratios of the past. Determining the right level of financial reserves requires difficult judgments about the company’s prospects and its access to capital markets. Imprecision and trade-offs are unavoidable. Nevertheless, the underlying principles are quite straightforward, and the key elements are similar to those implicit in any inventory management decision. To estimate the optimal level of financial reserves, an executive must understand. 1. The costs of holding financial reserves. Just as a purchasing manager must know the interest expense associated with the company’s inventory of components or raw materials, a CFO must have a handle on the implicit and explicit costs of maintaining unused debt capacity or excess cash. 2. The risks that reserves protect against. Physical inventory is held as insurance against production disruptions or unexpected changes in demand or availability of raw materials. Financial inventory also buffers against particular risks, especially the risk of being unable to raise equity capital when it’s needed. 3. Potential financial needs. If the worst should happen, how much cash will your company need? Judgments about costs, risks, and needs will help management set a target for total reserves. Once that is done, managers need to determine: the composition of reserves—the right mix of unused debt capacity and liquid investments—and procedures and controls for their effective management. Costs of Holding Financial Reserves Unlike the costs of holding physical inventory, which most companies monitor, the costs of carrying financial reserves are almost universally overlooked. Managers seem to think that the security of large liquid investments or a high-grade bond rating is free, and so while they frown on excessive physical stocks, they applaud bloated financial reserves. Financial reserves do have a price, however, sometimes a substantial one. Estimating this price is undeniably tricky. Generally Accepted Accounting Principles ignore it, while academics have argued the issue for decades without reaching a consensus. Despite the ambiguities of measurement, it is time managers began to realize that financial reserves can be expensive. The decision, for instance, not to take advantage of $ 1 million in borrowing capacity or to maintain $ 1 million in excess cash, is tantamount to a decision to use $ 1 million more equity than needed—since the company could use the debt or cash to retire the equity. And equity usually costs a company more than debt, for at least two reasons. In the first place, of course, stocks are a riskier investment than bonds. A business is legally obliged to make interest payments to its bondholders but has no equivalent obligation toward its stockholders. Stockholders are more exposed not only to the vagaries of the company’s marketplace but also to the risk that top officers will mishandle the company’s assets. Not long ago, for example, Allegheny International’s shareholders were dismayed to discover that the profits they thought belonged to them were being frittered away on nicely appointed corporate jets. In the second place, as everyone knows, Uncle Sam subsidizes debt by allowing businesses to deduct interest expense from their net income. There is no such subsidy for dividends. (Tax reform has rendered moot the old argument that the tax subsidy on debt might be offset by the tax penalty on interest income faced by some investors.) Using equity instead of debt can therefore have a considerable implicit cost. To illustrate, if a company’s cost of new equity is 15 % , its tax rate is 30 % , and its lenders are willing to provide additional debt at 10 % , then the cost of its unused debt capacity is 8 % per year (cost of equity minus the after-tax cost of debt). In other words, if $ 1 million in equity costs the company $ 150,000 per year and $ 1 million in debt costs $ 100,000 less $ 30,000 in tax savings, or $ 70,000 per year, then failure to borrow the $ 1 million will cost the company $ 80,000 annually. When reserves are held in the form of excess cash, the same arithmetic applies. If the company in the example above maintains $ 1 million in cash invested at 8 % (producing $ 80,000 in interest less 30 % in taxes for a net annual income of $ 56,000), then the net annual cost of holding the cash instead of using it to retire stock is $ 94,000 or 9.4 % (cost of equity, $ 150,000, minus the after-tax ROI, $ 56,000). Although the formula is simple—cost of reserves equals marginal cost of equity minus marginal cost of debt or return on invested cash—applying it is anything but, since in the real world executives are never given a neat marginal cost of equity or debt. While the capital asset pricing model is helpful in calculating the marginal cost of equity, it requires assumptions and estimates that may not be reliable or readily available. The cost of holding financial reserves is thus a soft number, based on judgment and guesswork. However hard it is to estimate the cost of holding financial reserves, ceasing to hold them often shows that the cost has been great. Recent recapitalizations where companies have slimmed down their financial inventories have produced enormous gains for shareholders. Consider the case of Unocal. Before T. Boone Pickens launched his celebrated takeover attempt in 1985, the company had a low debt-equity ratio and ample unused debt capacity. After Pickens’ raid, Unocal reluctantly issued $ 4.2 billion of debt and bought back 52 % of its stock. Total value to shareholders of the recapitalization (plus a 20 % cut in capital expenditures): $ 2.2 billion, or a gain of 35 % . Few cutbacks in physical inventory have ever had such an impact. And Unocal is no anomaly. In company after company—CBS, FMC, and Arco, to name just three—drastic reductions in financial reserves, combined with other restructuring steps, produced huge benefits for shareholders and revealed the magnitude of the carrying costs previously incurred. In fact, some observers give much of the credit for the 1984–1985 bull market in equities to stock buy-back programs undertaken by scores of companies in those years. Managers, too, share in the cost of holding financial reserves and benefit from their elimination. Although Unocal’s chairman, Fred Hartley, was dead set against leveraging up the company, he made out like, well, a corporate raider. The value of his stock and options soared by millions, thanks to the debt Pickens forced on Unocal. Holding financial reserves also carries an intangible price for executives less fortunate than Fred Hartley. Unused debt capacity and excess cash attract raiders, who constitute a direct threat to the position and perks of incumbent executives. One investment banker’s advice regarding debt capacity is simple: “Use it or lose it.” For private or closely held companies, the issue of hostile takeovers does not arise. Instead, owners face the danger of low personal diversification. Unused debt capacity in these cases represents personal wealth tied to a single business when it could be invested in other enterprises, thus reducing risk in the owner’s investment portfolio. The Risks That Reserves Protect Against We have seen that the costs of financial reserves can be substantial. But what of their benefits? What kind of protection does excess cash or an excellent bond rating really provide? What did Unocal’s shareholders give up for the 35 % appreciation in the value of their stock? Financial folklore tells us that the bogeyman scared away by low debt and too much cash is bankruptcy. A company with high business risk should prepare for the worst by stockpiling financial reserves. According to this view, Phillips Petroleum crippled itself with debt in order to ward off Carl Icahn and Pickens, and could even go under if oil prices decline. Now, obviously business risk is of great concern to lenders and so will affect borrowing capacity. A software house cannot borrow as much as a utility. But high business risk by itself does not justify unused debt capacity or excess cash. The traditional view of financial reserves and business risk is flawed in several respects. First, financial reserves cannot save a failing business. If a company’s operating costs consistently and significantly exceed its revenues, financial reserves can at best only delay bankruptcy. With labor costs much higher than its competition, Continental Airlines was headed for extinction after deregulation, regardless of its debt load. Financial reserves can only tide a company over temporary adversity. Second, even in a case of temporary adversity, financial reserves are necessary only to the extent that a company is unwilling or unable to raise new equity to restore its solvency. Conventional wisdom ignores the fact that corporate debt is potentially reversible. Unlike credit-card junkies or Latin American governments, business corporations can, in principle, issue new stock to retire the debt on which they cannot easily make interest payments. As long as the underlying business is basically sound and sources of new equity are available, a big debt load is not a crippling affliction but a burden that can be shed. Frank Lorenzo’s Texas Air is a company that seeks to exploit the reversibility of debt. Although it pursues a gutsy strategy in a risky business, Texas Air seems rarely to keep a dollar more equity in its capital structure than it needs to. In other words, it is usually leveraged to the hilt. But when the company needs more cash for new investment or faces difficulty in servicing its debt, Texas Air is not shy about raising new equity. Directly or indirectly, Texas Air issued stock six times in 1986 alone. As long as its underlying business is healthy and the stock market accommodates its new issues, there is no reason why Texas Air cannot continue to thrive on high leverage. Another conventional belief about financial reserves is that they help CFOs maintain control of their companies, since new equity owners do not have to be brought in every time the company is short of funds. This attitude may have made sense when there were no raiders on the prowl for underleveraged companies, but at the moment it is foolish. Why run the risk of attracting raiders now in order to avoid possible erosion of control in the event that stock must be issued next year? The Leveraged Company in Hard Times (in millions of dollars) In fact, from a manager’s as well as a shareholder’s point of view, the value of financial reserves lies almost exclusively in the protection they provide against failures of the equity market. If a company could always issue stock at a fair price, it would not need to hold any reserves. It is only the danger that equity financing will be unavailable at a reasonable price—and the consequent risk of having to conduct a fire sale of its stock or assets—that makes the cost of carrying financial reserves worth paying. A reasonable price, it must be stressed, refers merely to a price that fully reflects a company’s long-term prospects without overemphasizing its short-term financial difficulties. Reasonable does not mean high. Financial reserves cannot protect stockholders against permanent business setbacks that may depress the fair price of a company’s equity, just as they cannot prevent an inevitable bankruptcy. Assessing Equity Market Risk The danger for CFOs without reserves is that the equity market will spurn their companies’ stock. Of course, their assessment of that risk will have much to do with their beliefs about the efficiency of stock markets. Firm believers in an efficient market may totally discount the possibility of equity market failure and find Texas Air’s approach the clear strategy of choice. Skeptics, myself included, may not place so much faith in Wall Street. We wonder if stocks are always fairly priced. We wonder what fundamental change took place on October 19 that caused stocks to lose nearly a quarter of their value. We wonder how many companies would have been able to issue equity at a fair price on October 20. For skeptics, the following guidelines for evaluating equity market risk may be useful. To begin with, equity markets are less likely to give short shrift to large, closely followed NYSE companies than to smaller, younger companies trading over the counter. And in view of the substantial costs to shareholders of maintaining reserves, well-established companies should consider taking fuller advantage of their available debt capacity. There is nothing reckless about this policy as long as managers are not deterred by fair but low stock prices from issuing equity whenever the need arises. Insurance against the risk of inability to raise equity when the need arises is more justifiable for: Privately held companies with no simple mechanism for issuing stock quickly. Replacing debt with equity in such companies requires complicated, time-consuming negotiations between existing and prospective shareholders and, sometimes, creditors. Interestingly, while many large, publicly held companies with easy access to new equity maintain excessive financial reserves, many of the smaller businesses that have gone private in recent years—thus losing their ability to issue stock quickly—are taking on enormous amounts of debt. Small companies whose stock is thinly traded. Hundreds of companies trade over the counter, where it is difficult to sell several thousand shares even in a bull market. In a bear market, investor demand for these stocks can totally evaporate. Growth companies, like Genentech and Microsoft, whose perceived value on the stock market depends on expectations about future profits from yet-to-be-developed products. Since there is no objective way to assess the profitability of these companies ten years from now, their stock prices are subject to extreme swings. Such companies run a very real risk of being unable to raise equity when they are out of fashion. Other factors managers might consider in determining whether their companies need protection against the vagaries of the stock market include: The volatility of the stock price. Large price fluctuations in the absence of large shifts in competition or demand suggest that the market is having trouble valuing the company. How well the stock stood up the last time the company faced business difficulties. If the stock price fell much more than the CFO believes was justified, the company probably needs financial reserves to deal with future crises. Stock analysts’ grasp of the company’s investment needs. If the investments are in familiar, straightforward projects, the company will probably be able to raise equity at a reasonable price. But if outsiders cannot easily analyze the investments—perhaps because the company cannot jeopardize its competitive position by providing all the necessary information—fairly priced equity may be harder to come by. Estimating Potential Needs Just as the risk of supply disruptions does not justify an infinite stockpile of raw materials, so high equity market risk does not warrant unlimited financial reserves. Managers must estimate how much cash the company will need in the event of equity market failure. Equity markets are of course most likely to be inhospitable when the company is going through difficult times, say a downturn in demand or an adverse change in interest rates. To protect against a stock market overreaction to the company’s troubles, the CFO may decide to maintain one or a combination of several different kinds of reserves. 1. Coverage Reserves. The financial officer may believe that lenders are too optimistic about the company’s ability to cover interest payments. If, for example, lenders think a company capable of carrying $ 50 million of debt under poor business conditions while management believes $ 40 million a more realistic number, the company can forgo the use of $ 10 million in available debt capacity and treat it as a coverage reserve. 2. Operating Deficit Reserves. If management fears that cash flow in lean times may be insufficient to cover even normal operating expenses, it can earmark a reserve to cover the shortfall. 3. Bottom-Fishing Reserves. Farsighted CFOs can create an investment reserve to take advantage of the attractive investment opportunities that can present themselves when the company’s industry is troubled and competitors are strapped for cash. 4. Development Reserves. Management may also consider an investment reserve for those occasions when the company is in no particular trouble but the stock market won’t give it capital to fund its growth opportunities. Aerospace companies face huge cash needs at the start of a new product cycle. Since profit margins tend to be low at just such times—learning-curve cost reductions don’t arrive until later—stock prices may be depressed. Reserves can allow such companies to fund their investments without issuing equity at throwaway prices. Distinguishing between crisis reserves (items 1, 2, and 3) and non-crisis investment reserves (item 4), is important since the total reserve will be the larger of the two groups, not their sum. By definition, the two circumstances cannot occur simultaneously. 5. Buy-back Reserve. Finally, in the rare circumstance of extreme overpricing of a company’s stock, management may establish a reserve with which to repurchase stock when the price eventually declines to a more reasonable level. The only limit to the size of this reserve is the market’s willingness to accommodate new stock issues at an inflated price. (See the insert, “Selling High.”) Selling High In the same way that astute oil refiners stockpile crude when the market is depressed, CFOs may consider building financial reserves if they are convinced their stock is significantly overvalued. In such a case, it makes no sense to liquidate reserves and buy back stock. It may be quite profitable to issue overpriced equity, hold the proceeds in reserve, and buy back the stock when it retreats to more reasonable levels. In addition to generating trading profits, this strategy may, as a bonus, stabilize a company’s stock price. A rollicking price chart is a boon to short-term traders and a great nuisance to everyone else. While corporate buying and selling cannot eliminate volatility, it may prevent extreme swings by providing valuable and emphatic signals to the market about the fair value of the stock. One might even argue that if companies had taken the opportunity to raise new equity in 1987 instead of standing by as stocks rose into the stratosphere, we might have been spared the excitement of October 19. On the other hand, the sell-high strategy presents some ethical and practical difficulties. For example, when a company issues overpriced equity, existing shareholders gain at the expense of new shareholders, which raises an ethical question: Is it a manager’s duty to maximize value only for existing shareholders, or does the company also have a responsibility to shareholders-to-be, even if they are only speculators? On the practical side, while a reputation for astute timing in issuing stock may help dampen volatility, it may also make it difficult for a company to raise equity when it’s really needed. After all, who wants to buy the stock of a company known for issuing overvalued shares? Moreover, attempting to sell stock at a high price exposes CFOs to personal risk because if the stock continues to rise after issue, they may be accused of having “given away” the company. To target the amount of reserves a company should carry, CFOs must consider all three of the determinants—costs, risks, and needs—together. The greater the perceived risk of equity market failure and the lower the costs of carrying reserves, the closer the targeted sum should be to the estimate of maximum needs. At one extreme, privately held companies and the Microsofts and Genentechs may be justified in carrying their full estimated needs, regardless of the cost. At the other extreme, public utilities need carry only a small fraction. For all the companies in between, there is no mechanical formula. Experienced judgment and personal preference will inevitably play an important role. Nevertheless, an explicit assessment of costs, risks, and needs will be far more helpful in forming reasoned judgments and educated preferences than today’s arbitrary formulas. Composition of Reserves Once they’ve set the size of their reserves, managers must decide how to hold them. Some growth companies have no choice about the composition of reserves. Their debt capacity is zero, so any reserves they hold must be liquid. Most other companies have more leeway and can hold varying combinations of cash and unused debt capacity. The principal trade-off is between cost and predictability. Reserves held as unused debt capacity have lower risk-adjusted carrying costs than cash. Maintaining unused debt capacity can be thought of as lending oneself money. By contrast, excess cash is always invested in someone else’s securities. The clear comparative advantage of investing in one’s own company—an insider’s knowledge of the risks, elimination of transaction costs and intermediary fees and profits—allows a business to earn higher risk-adjusted returns on its “investment” and thus reduce the costs of maintaining reserves. The main disadvantage of unused debt capacity is its tendency to evaporate. If the company should have a crisis, the CFO may find that potential lenders won’t even return phone calls. That problem obviously doesn’t arise with excess cash, which is also more quickly available. In general, then, companies with credit standings as shaky as their stock market prospects must be willing to hold cash reserves despite their higher cost, while companies with readily mortgageable hard assets can depend on cheaper unused debt. (A company faced with high credit market risk but low equity market risk may therefore keep debt capacity low and cash reserves high. Texas Air, for example, has a high debt-equity ratio but holds up to a billion dollars in cash.) Another apparent advantage of a cash reserve is the protection it gives the company from a rise in interest rates that would make borrowing prohibitively expensive. In strictly economic terms, this can be an illusory advantage, since businesses can now protect themselves against movements in interest rates with instruments like options, futures, caps, and collars. In practice, of course, some boards of directors may refuse to approve use of such newfangled tools. In addition to determining the split between cash and unused debt, managers must also decide how to invest their cash. Traditional insistence on protecting capital at all costs mandates investment in high-grade short-term paper when a diversified pool of equities might be more appropriate. The trade-off here is between cost and completeness of coverage. Investing in equities minimizes the cost of carrying reserves because over the long haul a stock portfolio will handily outperform short-term instruments. On the other hand, short-term instruments give more complete coverage. Recall that financial reserves protect a company against undervaluation of its stock. But undervaluation may result from the company’s fall from favor in the market or from a general dip in stock prices. Investing in a diversified pool of equities protects against the former danger only, while investing in short-term instruments protects against broad bear markets as well. (In the never-never land of financial theory, this argument does not hold because stockholders can compensate for whatever investment policy the company chooses to follow. For example, if stockholders learn that the company is holding excess cash in the form of short-term instruments, they will in theory reduce their own short-term holdings and increase their stock portfolios. The real world, alas, is populated with investors charged with investing in equities and nothing else. Moreover, they have no way of telling how much of a company’s cash holding is too much.) In my opinion, officers of publicly held companies should buy the cheaper and more limited form of insurance, since they have neither the expertise nor the mandate to protect their shareholders against a general market collapse. They should invest excess cash in short-term instruments only if their view of the market is so strong that they will commit their own money to purchases of puts on stock index futures. Controls and Procedures To establish and maintain an optimal balance at minimal cost between cash reserves and unused debt capacity, companies need to set up procedures and controls to estimate: 1. Their maximum borrowing capacity. To determine the capacity that is actually unused, companies must estimate the loan value of everything owned, including fixed assets and receivables. 2. The amount of cash they need for purely transactional purposes. This estimate serves as a baseline against which to measure what is truly excess. 3. Their degree of stock market risk. 4. Their future cash needs under conditions of unexpected adversity or rapid growth. 5. The optimal size of their buy-back and other reserves. 6. The composition of their liquid investments. 7. The continuing costs of cash and unused debt reserves. Financial officers and their staffs can perform some of these tasks unassisted, but top managers must exercise their judgment at every stage of the process. The world has changed since the days when perfunctory periodic review and ratification of the status quo were the norm. Just as the best of the oil companies have responded to turbulence in the oil markets by learning how to trade and speculate in the crude markets, CFOs need to turn the turbulence in the capital markets to their advantage by administering the size and composition of their financial reserves. Managers may wonder why today’s creditors are willing to take on equity-like risks without demanding equity-like returns. They may also worry that running on low reserves now could lead to gouging at the equity pump later. But they cannot turn their backs on the opportunities for shareholder value offered by the easier availability of debt—and an occasionally capricious stock market.
