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 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 0.

Let us assume a company’s Current Assets minus two times its Current Liabilities are €1000 and its Cash and Short Term investments equal €500.

You can see 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 must be deducted in the Enterprise Value formula.

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 thus decided to use one of Benjamin Graham’s margin of safety rule 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.