Reposting generically:
How does a huge investment in cash affect a company's return on equity and its sustainable growth rate? As shareholder, would you endorse a large investment in cash? As a senior executive, how would you defend the investment?
To understand how a huge investment in cash affects a company's return on equity (ROE) and its sustainable growth rate (SGR), we need to first define these two concepts.
1. Return on Equity (ROE): ROE measures a company's profitability in relation to its shareholders' equity. It is calculated by dividing the net income of the company by its average shareholders' equity. ROE indicates how efficiently the company is using its shareholders' investments to generate profit.
2. Sustainable Growth Rate (SGR): SGR represents the rate at which a company can grow its sales, profits, and dividends while maintaining a constant financial structure. It is a measure of the company's ability to grow using its retained earnings and without relying on external financing.
Now, let's explore how a huge investment in cash impacts these two metrics and consider whether endorsing such an investment would be beneficial.
1. Impact on Return on Equity (ROE):
When a company makes a large investment in cash, it typically means that it is holding a significant amount of idle or unproductive capital. This can decrease the company's profitability and consequently impact its ROE. The larger the amount of cash not being utilized effectively, the lower the return it generates, thus negatively impacting ROE.
2. Impact on Sustainable Growth Rate (SGR):
A company's SGR is influenced by its profitability, retention ratio (portion of earnings retained in the company), and its asset turnover ratio (how efficiently it generates sales from its assets). If a company invests a substantial portion of its cash in productive assets or projects, it can potentially increase its profitability and asset turnover, leading to a higher SGR. However, if the investment in cash does not generate sufficient returns or there aren't suitable investment opportunities, the SGR may be affected negatively.
As a shareholder, whether to endorse a large investment in cash depends on the company's specific situation. Factors to consider include the company's financial position, investment opportunities, and its long-term strategy. If the company has a solid track record of generating high returns on its investments and has a clear plan for utilizing the cash effectively, endorsing the investment could be justified.
As a senior executive defending the investment in cash, it would be important to provide a comprehensive rationale. This may include explaining how the investment aligns with the company's strategic objectives, potential benefits and risks, expected returns, and how it fits within the company's financial plans. Clear communication about the reasons behind the decision can help gain support from shareholders and stakeholders.