We set up our accounting system to match the way we like to think about financial capital. We like to think of capital as a big stockpile, something that firms start with and draw down during the course of their operations.
But in fact it doesn’t work that way. Or at least, not all the time. Companies keep some of their capital in reserve. Reserves are like emergency stockpiles; they allow firms to avoid drawing down on their own capital.
Firms borrow money—that is, they get someone else to give them capital—so that they don’t have to sell off assets or go into debt when they grow or face an emergency. They hold reserves so they can avoid borrowing when times are good.
Here’s how it works in practice: When a company has extra cash flow, it doesn’t necessarily want to use the money right away. It could invest the money in new factories or research, but it could also just sit on it for awhile instead of paying dividends or repurchasing stock. If the firm thinks its stock is undervalued, by sitting on its cash it can increase its earnings per share without making any risky investments.
Financial leverage allows a company to increase its return on capital by increasing its debt. But the cost of debt is risk: if cash flows fall, or interest rates rise, debt becomes more burdensome.
The way companies reduce this risk is by having cash reserves on hand, so they don’t have to draw down on their own capital. Reserves increase a company’s return on equity, because they allow the company to avoid having to go to outside investors when cash flow is low.
Cash reserves are an important form of financial leverage–more so than many people realize.
Many firms have a special type of account called a “reserve,” separate from their regular accounts. Money in a reserve can be used to pay for unexpected future expenses, but cannot be used to pay for day-to-day expenses.
In accounting, showing that money is “in a reserve” is the same as saying that it isn’t immediately available to pay for expenses. To get at the money in a reserve, a firm has to draw down on its own capital–that is, sell off assets or borrow money.
If a firm has cash in its reserve accounts, it’s safe from going bankrupt. But if it needs to draw down on its capital because it doesn’t have enough cash, it’s in trouble.
The idea of a reserve is both simple and smart. A firm should not be forced to use its own capital if there are any other sources of cash available. It should only be allowed to do so if there really is no other way out.
When a company runs out of money, its options quickly dwindle. It can try to raise more cash—a difficult and expensive proposition. Or it can sell assets—but if it’s in trouble, why would anyone want to buy those assets? Finally, it can default on debts that come due.
In the past, the threat of bankruptcy has been a powerful discipline on corporate managers. But in recent decades, companies have learned how to get around it. They create financial reserves—essentially pools of money they don’t have to pay interest on or principal on—in a manner that makes them look less indebted than they really are.
There’s a powerful and often overlooked idea in finance: Reserves are capital. That sounds silly, I know. If you have $100 in your checking account, that’s not capital. It’s cash.
But if you have $100 in your checking account and the bank owes you $100 on a reserve requirement, then mathematically it is exactly the same thing. It is capital.
Using accounting terminology, if you have a reserve requirement of 10%, then by definition deposits are 90% reserves. It doesn’t matter if they are all in your checking account or are spread among various other accounts at the bank. Reserves are capital because they are instantaneously convertible to cash at the central bank’s discretion, while loans are liabilities because they must be paid back at some point in time, usually with interest.*
A business holds assets and liabilities. Assets are the things it owns (cash, inventory, buildings, equipment, land, patents) and liabilities are the promises it has made to other people (customer orders, long-term debt). The difference between assets and liabilities is equity – the business’s claim to own itself.
The value of a firm’s equity can be thought of as the value of its assets minus the value of its liabilities. This is the accounting identity that emerges from double-entry bookkeeping.
If a firm were to sell all its assets and pay off all its liabilities, it would be left with no net worth – no wealth – and zero value for its stock. This is why firms usually try to avoid going bankrupt.
Let’s start with a simple question: why do companies need cash?
Emil is a contributor at Accountant Log. We are committed to providing well-researched, accurate, and valuable content to our readers.
