The following caveats apply when using net cash as a measure of balance sheet strength:
Cash Must Be “Unencumbered and Non-Restricted”
Cash on the balance sheet may not be immediately available to the parent company or the group due to legal or regulatory restrictions. For example, for property developers in certain countries such as Malaysia, cash collected from buyers have to be deposited into Housing Developer’s Accounts and withdrawn only upon progressive billings. Also, for companies with non-wholly owned subsidiaries with less than 100% ownership by the parent, cash at the subsidiaries level may not be readily available to the parent. In other cases, cash balances may be pledged against the debt of the company’s associates which are not consolidated at the Group level.
Cash Must Be “Non-Operating and Excess”
Certain companies like supermarkets and convenience stores have to retain a certain amount of cash for working capital needs, although this is less relevant in the increasingly cashless electronic payment world today. Other acquisition-hungry and capital-intensive companies are likely to draw heavily on their cash balances and the cash on the balance sheet is unlikely to be truly “excess” to the company’s operating and investment needs.
Cash Balances Are Real
Companies which are debt-loaded and/or non-dividend paying despite huge cash balances, are at high risk of faking their cash balances.
Off Balance Sheet Liabilities Should Be Included as Debt
There are two types of leases: finance leases which appear on the balance sheet as financial liabilities and operating leases which only show up in the income statement as rental expenses. This does not reflect economic reality. The most common form of operating leases is rental of store space by retailers. Retailers are usually faced with two choices: (1) borrow money to own the store space and repay the debt over the period of the loan; or (2) pay rental expenses (fixed commitments) over the period of operation. In reality, the operating lease is no different from a loan. Operating lease expenses should be capitalized to approximate the value of debt on the books.
Provision of guarantee for debt of sister companies by parent company, unsettled lawsuits, binding commitments such as a take-or-pay contract, debt of unconsolidated joint ventures and associates are other forms of off-balance sheet liabilities that rightfully should be included as debt.
Hybrid Securities Should Be Included as Debt
Common hybrid securities include preference shares, perpetual securities and convertible debt.
Preference shares should be considered debt, as coupons on preferred shares have to be paid before dividends can be paid to ordinary shareholders.
Similar to preference shares, perpetual securities are ranked ahead of equity in terms of distributions. The company has the option but not the obligation to repay or convert the perpetual securities at its callable date.
Convertible debt, as its name suggest, is still debt albeit more expensive. Furthermore, there is a possibility of conversion to equity and dilution of existing shareholders.
Use ratios like gross debt-to-equity ratio or debt-to-asset ratio, instead of net gearing, to measure the amount of leverage that a company has. Also, look out for possible negative earnings and/or working capital, and capital expenditure requirements that will draw down on current cash levels.