The document discusses the large cash reserves held by major Indian IT companies and questions whether this level of reserves is necessary. It notes that the average cash-to-assets ratio for the top 3 IT companies has increased from 22% to 31% over the last 5 years. However, there do not seem to be valid operational reasons for this increase, as the companies have better debt collection processes and more flexible cost structures. The large cash holdings are an inefficient use of capital resources and the practice of stockpiling cash will hopefully change.

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Date:16/08/2010 URL:
http://www.thehindubusinessline.com/bline/ew/2010/08/16/stories/2010081650040100.htm
Back How much cash does a company need?
Do IT firms seem to think there's no such thing as too much cash?.
Amit Garg
Are Indian IT companies among the riskiest enterprises in the world? That's the question one is
forced to ask when one looks at their cash reserves.
Cash reserves can be computed by looking at the bank balance, FDs and other liquid investments
that a company has. It is perfectly normal for a company to keep a certain amount of extra cash
on its balance sheet. This helps a company tide over a difficult period and also gives it the
flexibility to act fast on any opportunities that it may spot. But cash held by a company is typically
in the form of low-yield deposits, which is a less efficient use of capital than an investor would
desire. The traditional argument, therefore, is that companies should keep an optimum level of
cash on hand and return the rest to their shareholders.
In a risky or unclear environment, however, it is normal for a company to increase its cash
reserves. This is true across the world. A recent study found that US companies have increased
their overall cash to assets ratio from 10.5 per cent in 1980 to about 24 per cent in 2004. In fact,
larger companies tend to have the higher cash reserves. The general view seems to be that there is
no such thing as too much cash.
Indian IT companies have subscribed to this view wholeheartedly. The average cash to assets
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ratio for three of the top IT companies has increased from 22 per cent to 31 per cent over the last
five years.
One can argue that cash to assets is not the only ratio that a services company would look at.
Some analysts prefer the cash to operating expense ratio. This ratio tells us how many months a
company would be able to sustain its current expenses without any revenues whatsoever. Those
numbers don't look particularly good either (i.e, the lower, the better). Over the last five years,
the cash to expenses ratio has increased from 20 per cent (2.4 months) to 40 per cent (4.8
months). In one case, the number is as high as 71 per cent (8.5 months).
What is the need for this increase in cash reserves? Let's tick off the reasons.
One of them could be the “war chest” argument — keeping money aside for acquisition
opportunities. However, there have been very few large acquisitions in the sector, and it seems
unlikely that this trend will change significantly. Besides, in the event of a large acquisition, it would
not be that difficult to raise money from the market. Some would argue that it would also create
more discipline in acquisitions.
So acquisitions can't be the reason — there seems neither the intent nor the requirement.
Another reason could have been investments in infrastructure creation. But given the recession,
few companies are expanding their facilities in any meaningful manner. There are also several
rental opportunities available today — a consequence of overbuild in the real-estate sector. So a
company doesn't necessarily need to build capacity ahead of demand.
The other reasons would need to be operational. Bad debts and longer collections cycles could
be one of the risks of the environment. But that doesn't seem to be the case either. In fact, most
large IT companies have been tightening their risk assessment and collections processes over the
years and have better collection ratios than they did a few years ago.
Similarly, companies have moved to create tighter performance management systems and a more
variable employee salary structure.
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There have also been increases in sub-contracting — which allows for (relatively) short-term
changes in staffing. As a result, an IT company does have some ability to align its cost structure
with the revenue situation. If the need arose, they could reduce their staff costs.
So there really is no justifiable argument for the incredible increase we've seen in cash reserves. In
fact, there is also a perspective that the risk level in a larger services company is actually lower –
since the variability of a portfolio is lower than that of an individual account.
The tendency to stock-up on cash then boils down to a heightened risk perception about the
environment and the fact that investors seem fairly tolerant of cash hoarding practices. It is,
however, a very costly practice — and one that will hopefully change.
The author is a Director with MXV Consulting. He can be reached at amit_garg@mxv.in
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