Most people think cash is free… but that’s not the case for a business. Watch this video to understand the hidden cost of cash.
VIDEO SUMMARY
This is one of the topics that really separates Finance people from other business thinkers. In my previous video I discussed WACC. The cost of cash is a specific application of this concept. The idea is that cash is just another form of capital. And therefore cash has a cost, just like all other capital. Most people think of cash as free. You have $1 of cash, it’s worth $1. In a business, that’s not really true on a theoretical level. That cash came from somewhere, and it had a cost. A business might raise cash by issuing stock, or issuing debt, or being invested by the owner. The cash came from somewhere and there was a cost associated with raising it. A cost that is based on the riskiness of the business.
So what is the cost? It is your WACC. Because if you remember, WACC looks at all your different sources of capital and comes up with the average cost to acquire capital for your business. So when you raise money for your business, you pay this cost. So let’s say you raise the money, you can then decide to use it to build a building, manufacture products, or hold it as cash. So that cash has the same cost of capital as everything else. Another way to think of it, is as a bank loan. Let’s say you have a loan with a set interest payment of 10%. You got this up front payment of cash, and no matter what you do with it, you’re paying a cost for that at 10% each period.
So I hope I am expanding the way you are thinking about cash. But this isn’t just a theoretical idea. It’s very practical in your operations. Because what happens each year, is your managers get a budget. They have some amount of cash to spend to achieve their goals. Most people think of that cash as just free money. But that’s not the case. That cash came from somewhere and there’s a cost to it. So whatever your manager’s do with that cash for the year, it needs to generate more return on investment than the cash plus the cost to acquire the cash. Hopefully people are engaged in activities that eventually lead to company profits. This is not to suggest that it must be an immediate profit. Of course there are long term investments. But business people should be aware, in their long term strategies of how they are going to generate profits to account for the cost of cash. If you cannot overcome that hurdle rate, you are destroying value.
So now you might say, what if I gave you some cash? Would it be free then? So let’s look at the scenario where someone gives you a boatload of free money for your business (this is never going to happen by the way). But let’s say it did. No cost of issuing stock. No interest payments from issuing debt. They just gave it to you for free. At the very minimum, there is an opportunity cost. Because that person, could have put that money to work in a similar business and earned some rate of return. So it is still the same thing.
And this brings us to the heart of the issue. If you are a business, you should be generating profits that reflect the riskiness of your business, which is reflected in your cost of capital. If it is a really risky business, and your profits are at a low level similar to a low risk business, you are destroying the value of the capital that was invested in your business.
So I want to end by coming back to the idea that your business is a machine. Capital flows in one side and profits flow out the other. Cash is just any other form of capital, and all capital has a cost.
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Neither Zach De Gregorio or Wolves and Finance Inc. shall be liable for any damages related to information in this video. It is recommended you contact a CPA in your area for business advice.