Implications of Insufficient and Excess Cash for Future Performance

Many public firms report substantial and growing levels of cash on their balance sheets (e.g., Zuckerman 2005; Bates, Kahle, and Stulz 2009), making it increasingly important to understand the implications of cash holdings for future fundamental performance and stock returns. Opler, Pinkowitz, Stulz, and Williamson (1999) find evidence supporting a static trade-off model of cash holdings in which each firm has an optimal level of cash where the marginal benefit of holding additional cash is equal to the marginal cost. If firms have an optimal cash level, then holding more (excess cash) or less (insufficient cash) than this balance should have adverse effects on a firm's future fundamental performance and stock returns. While some attention has been given to the current and future performance of firms holding excess cash, little attention has been devoted to firms holding insufficient cash. This paper investigates the implications of insufficient and excess cash on both future return on net operating assets (RNOA) and future stock returns. Although a large body of accounting research has investigated the value relevance of operating cash flow both individually (e.g., Desai, Rajgopal, and Venkatachalam 2004) and as compared to income (e.g., Sloan 1996; Collins and Hribar 2000; Xie 2001; Cheng and Thomas 2006; Hafzalla, Lundholm, and VanWinkle 2011), there has been scant research investigating whether a buildup of cash flow, or lack thereof, affects firm value. This is despite the fact that financial statement analysis requires a determination of the cash holdings necessary for liquidity purposes and then decision making on how a firm will allocate the remaining cash between investment opportunities, dividend distribution, or the repurchase of shares (e.g., Stickney, Brown, and Wahlen 2004, 773; Palepu, Healy, and Bernard 2000, 12-20). This paper aids in fundamental firm valuation by helping financial analysts understand the implications of current and projected cash levels on future profitability.