Excess Cash

Excess cash is the amount of cash in excess of what the company needs to run its business, in other words cash that can be paid out to investors without harming the business.

 

Excess cash calculation

It is calculated as follows:

If Total Current Assets are greater than (2 x Total Current Liabilities), then Excess Cash is the lower of:

  • Cash and Short Term Investments or
  • Total Current Assets - (2 * Total Current Liabilities).

 

If Current Assets are not greater than (2 x Total Current Liabilities) then Excess cash is zero.

 

Excess cash calculation example

Let us assume a company’s:

  • Current Assets minus two times its Current Liabilities equals €1000
  • And its Cash and Short Term investments equal €500.

 

It has excess cash because Current assets are larger than two times Current liabilities.

Excess cash is thus €500, the lower of €1000 and €500.

 

Where does this excess cash formula come from?

Joel Greenblatt on his Magic Formula Investing website said only excess cash must be deducted when calculating the Enterprise Value of a company.

This makes sense as I am sure you will agree that a business cannot pay out all the cash on its balance sheet but only the amount more than it needs to run its business.

Unfortunately Joel does not mention how he calculates excess cash.

 

We went back to Benjamin Graham

We used one of Benjamin Graham’s margin of safety rules he wrote about in his book The Intelligent Investor which says:

Invest only in companies where the current ratio (Current assets / Current Liabilities) is more than 1.5.

We increased this ratio to two before assuming a company has excess cash on its balance sheet.

So as you can see a very conservative calculation.

 

How you can use the ratio

It is only used for calculation purposes and is not available as a screening value.

Available as a screening ratio: No (Excess cash is used in the calculation of Enterprise Value)

Available as an output column ratio: No (Excess cash is used in the calculation of Enterprise Value)

 

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