- Excess Cash = Cash a company has that is not required to operate the business.
- Investments
- investment in quoted or unquoted shares
- investment in properties (for a non property development company)
- investment in associate companies or JV (which account is not being consolidated into the group's account)
- Why Net out Excess Cash & Investment?
- Interest Income from Cash + Return from investments is not part of operating income.
- Dividing Operating Income by Total Book Value - yield too low for a return on capital for companies with significant cash balances.
- If we add back interest income (from cash) & return from investment to the numerator - it is not a fair measurement as interest income is low risk & low return investment
- Thus, the reason is to be consistent with the use of Operating Income as Earning measurement.
- Using the book value of assets to replace the book values of debt and equity
- Total equity + total debt in Eq (1) = Total Assets – Non-interest bearing Current Liabilities in Eq (2)
Eq (3): Fixed Assets + Current Assets - Non-interest bearing Current Liabilities - Excess Cash - Investments
- From Eq (2), Total assets = Fixed Assets + Current assets in Eq (3)
Eq (4): Fixed Assets+ Non Cash /Investment Net Working Capital
Eq (5): Fixed Assets + Receivables + Inventories - Payable
- Fixed asset - PPE, long-term lease payment, investment properties for a property company, biological assets for a plantation company [but not take in all assets ]
- Other non-current assets, e.g. long-term investment, tax payable, retirement benefits etc - it is not a invested capital in their real sense (It is arguable).
- Other current assets, e.g. tax credit, etc is removed.
- Other current liabilities, e.g. tax payable, dividend payable etc not consider as part of the working capital.
- Accounts payable - subtract it from IC is because it represents capital invested in the business by a company’s suppliers or contractors, not the company itself.
- If you use Eq (2), you are unknowingly taken them as part of the IC which is why it is different from if you use Eq (5).
- Eq (5) is what Greenblatt used in his magic Formula.
Excess Cash
- Company carry some cash and equivalents to meet short-term obligations, pay dividends, buy back stock, make acquisitions, etc.
- It may carry short-term investments, such as money market fund.
- Both of them can be grouped together and call it "Cash".
- Invested capital is a firm's physical plant, receivables, inventory, and so forth.
- Cash isn't really invested capital used to generate the company's revenues and profits. It should be subtracted out when calculate the Invested capital.
- Cash acts as a discount on the purchase price of the company. E.g. pay $1B to buy company with $250M cash in bank (and no debt) - in essence, you are only paying $750M -- This is why we subtract cash out from the enterprise value.
- Excess Cash = Cash is not required to met short term obligations which are listed in current liabilities.
- Excess Cash = Cash - Total Current Liabilites
- But, we might able to use the current asset to cover the current liabilities instead of using cash only
- Excess Cash = (Cash - Current Liabilites) + (Current Asset - Cash)
- While, Excess Cash shouldn't > Cash
- Excess Cash = Cash - Max[0, {CL - (CA - Cash}]
- TEV = Market Capitalization +Total Debt + Minority Interest - Excess Cash --> We have already added all "Debts" in the equation as total debts. If we were to consider this "debt" in the "excess cash" term and hence get a negative "excess cash", the EV will be jacked up higher.
- Excess Cash = Cash - Max[0, {(CL - Short Term Debt) - (CA - Cash}]
- For a company has too much current liabilities, it might have a deficit of cash - it need to find cash from somewhere (right issues? borrowing? etc... to meet short term obligation) --> and, ultimately this would increase invested capital, and increase the enterprise value.
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