<b>Amit Tandon:</b> A way out of the cash hoarding problem

If companies paid out large amount of earnings as dividends, cash accumulation would not be an issue

The outcry over the cash on Infosys’ balance sheet for buy-backs has brought into focus the use of cash that has been steadily allowed to accumulate on the balance sheets of companies. While TCS has agreed to spend Rs 16,000 crore on buy-back, this remains a burning issue for Infosys. The best use of accumulated cash is something all boards should constantly think about. After all, the use of cash, more broadly capital allocation and succession planning, are the two more important decisions boards get to take.

Cash on the balance sheet often dampens returns. For one, cash in the bank typically earns lower returns than cash deployed in business activities. In the case of Infosys, the business earns 15 per cent, while cash on its books yields eight per cent, muting returns. If this cash is returned to shareholders or deployed elsewhere, return ratios will improve.

Assuming there is no alternative use of cash, the more traditional way of returning it to shareholders is by way of dividends. If companies paid out large amounts of earnings as dividends, cash hoarding would not be an issue. But as cash accumulates to become a significant part of a company’s balance sheet, it starts to hurt the company.

The Securities and Exchange Board of India recently asked companies to publish their dividend distribution policy, and while this might address the issue of what to do with the cash in future, the use of accumulated cash needs to be addressed. 

Another option is share repurchase or buy-back. Under a share buy-back, the company uses this excess cash to repurchase its own shares, thereby reducing its outstanding shares. This is expected to give an immediate boost to the company’s share price. The logic is that the number of company’s outstanding shares have come down and if its profits remain unchanged its earnings per share (EPS) will go up. EPS is the quick and dirty measure of a company’s health. In general, closely linked to share price performance, it is the most commonly used proxy for a firm’s performance.

Tax rules in India favour buy-backs over dividends. Companies are required to pay a dividend distribution tax of 15 per cent on dividends. Along with surcharge and education cess, the effective tax rate is 20.9 per cent. The investor is charged at a rate of 10 per cent, if dividend income is higher than Rs 10 million annually. On the other hand, companies do not pay taxes on buy-backs. Buy-backs are subject to a securities transaction tax of 0.125 per cent in the hands of the investor, if done through the stock market route. Further, for shares held for more than 12 months, there is no long-term capital gains tax applicable. This makes buy-backs a more tax-efficient way of distributing cash to shareholders over dividends.

The pace of buy-backs has increased in FY17 and this trend is expected to continue. Among the S&P BSE 500 companies, only three sought shareholder approval for buy-backs in FY16. Contrast this with FY17, where until February 7, 2016, there were 15 companies that sought shareholder approval for buy-backs.

Illustration: Binay Sinha

Buy-backs also help “promoters” shore up their holdings, to the extent that they do not participate, but public shareholders do. From their perspective, there is the added advantage that the payment is not coming from their cash pool, but from the company. There are some well-known examples in the information technology sector, which did just this a few years ago, but recent data shows that promoters have started tendering their shares at the time of the open offer. In contrast, in professionally managed companies, share buy-backs are used to absorb the additional shares issued as a part of the Employee Stock Option Scheme (ESOP). This is more prevalent in the US markets.

Recently, buy-backs have become a well-established path for “divesting” the government’s shareholding. Last year, public sector undertakings used Rs 17,050 crore on buy-backs. More than 90 per cent of this went to the government, which brought down its holdings below 75 per cent in four of the five companies.    

While deciding whether to use the cash to pay out dividends or for a share buy-back, what should matter to boards and investors is the relative advantage of these to repaying debt, or investing in or acquiring new businesses. This is to say that buy-backs may not always be successful.

To be a success, buy-backs should be undertaken only if the share price is undervalued. Buy-backs signal the board’s view that the share is underpriced. Why buy something that is priced over the top? Conversely, the best time for a buy-back is when investors are fearful. Buying back at the top of the cycle can be counterproductive as far too money flows out. As with personal investing, it’s just not possible to time the market: An SIP-like option, wherein a fixed amount is bought back every quarter, might hold the key.  

Two other issues that boards need to debate are growth assumptions and alternative use of cash. 

If growth and profits are expected to fall faster than the reduction in outstanding shares, the share price might go into a downward spiral. Worryingly, there is now lower cash on the balance sheet to act as a backstop to the rapidly declining share price. Justdial is an example, where the buy-back was priced too optimistically, and within months the share was trading at a lifetime low.   

While the impact of a share buy-back is immediate, using cash or shares for acquisitions generally works its way into performance indicators over the medium term, provided the acquisition is sensible. Long-term value creation should always trump a short-term fix.

The author is founder and managing director, Institutional Investor Advisory Service India Limited. Twitter: @amittandon_in