When Cash is King vs When Cash is Trash

Cash. It's better to have too much than too little. But there can be too much of a good thing. 

When Cash is King
Capital MONEY! knows that when unexpected obligations arise that there is nothing better than having a pile of cash ready to handle it, and that's why we stress the importance of an emergency fund in our 10 Steps Guaranteed to Build Wealth article. This is as true for businesses as it is for people. Similar to how a person should have an emergency fund, a business should hold more than enough cash to pay for all its operating expenses and absorb any adverse impacts that can occur through the normal course of business. 

We also believe that the success of a for-profit enterprise is its ability to generate free cashflow over the long term. A good business is one that generates a lot of free cashflow relative to the amount of money (aka capital) invested in it. All else equal, it is easy to see that you would rather own Business A than Business B. 

Business A:
Annual Free Cash Flow: $10 Million
Capital Invested: $100 Million
Annual Free Cash Flow / Capital Invested: 10%

Business B:
Annual Free Cash Flow: $10 Million
Capital Invested: $200 Million
Annual Free Cash Flow / Capital Invested: 5%

When Cash is Trash 

There is such thing as too much of a good thing. The incremental value of cash diminishes rapidly after you've built up a conservative emergency fund. Suppose you are extra conservative and feel comfortable with an emergency fund to cover twelve months of all your expenses. Any cash you hold in excess of that amount will be will be working against two powerful forces.. 1. Opportunity Cost and 2. Inflation. 

• Opportunity cost is all the money you would be making if you'd invested the money instead of holding it in unnecessary cash. Which we can reasonably assume is the 7% annual returns you'd get if you invested the money in a low cost ETF. We explain ETFs in our article on Investing and the Power of Compounding
• Inflation is the perpetual decline in the purchasing power of money. That means that $1 today buys less than $1 bought 50 years ago. And that $1 10 years from now will buy less than $1 buys today. On average, inflation makes cash worth 2% less every year. Think of your cash like a piece of wood, and inflation are termites that eat more and more of your cash the longer you let it sit around. 

The average combined cost of holding too much cash is 9% annually. That is the 7% you're not getting by not investing + 2% loss of value due to inflation. Figure 1 shows that you'd be expected to lose $101,835 by holding $10,000 cash for 35 years instead of investing it in an ETF that tracks the total stock market. This is the decision someone makes when they hold excess cash. 

Holding money in cash is the same effort as investing in an ETF - both are zero effort, you initiative the transfer or purchase once. Suppose a wizard knocked on your door and demanded that you choose from one of two options else he turn you into a toad. He demands that you either pay him $5K or he pay you $97K. So you decide to "play it safe" and pay him $5K. That is the choice we make when we hold excess cash instead of investing it. 

Many people feel that holding cash is safer than investing it. It is correct in the very short term that investments are more likely than cash to lose value. And that is why Capital MONEY! strongly recommends that every person and business maintain a conservative cash pile for emergencies. Furthermore, we believe that people shouldn't invest with money that they might need in the next 1-5 years. But if your time horizon is long and you have a healthy emergency fund, you pay an incredibly high price for any money you hold in cash. 

Figure 1: 

• This table represents the cost of holding cash

Figure 2:

• This is what termites eating away your cash looks like 

Annual Rate of Return		-2.00%
Year	Total Amount	Total Return $s
0	$10,000
1	$9,800	-$200
2	$9,604	-$196
3	$9,412	-$192
4	$9,224	-$188
5	$9,039	-$184
6	$8,858	-$181
7	$8,681	-$177
8	$8,508	-$174
9	$8,337	-$170
10	$8,171	-$167
11	$8,007	-$163
12	$7,847	-$160
13	$7,690	-$157
14	$7,536	-$154
15	$7,386	-$151
16	$7,238	-$148
17	$7,093	-$145
18	$6,951	-$142
19	$6,812	-$139
20	$6,676	-$136
21	$6,543	-$134
22	$6,412	-$131
23	$6,283	-$128
24	$6,158	-$126
25	$6,035	-$123
26	$5,914	-$121
27	$5,796	-$118
28	$5,680	-$116
29	$5,566	-$114
30	$5,455	-$111
31	$5,346	-$109
32	$5,239	-$107
33	$5,134	-$105
34	$5,031	-$103
35	$4,931	-$101
Total		-$5,069

Figure 3:

• This is what your money could be doing instead of being eaten by termites

Annual Rate of Return		7.00%
Year	Total Amount	Return on Starting Amount	Return on Investment Returns	Total Return $s
0	$10,000
1	$10,700	$700	$0	$700
2	$11,449	$700	$49	$749
3	$12,250	$700	$101	$801
4	$13,108	$700	$158	$858
5	$14,026	$700	$218	$918
6	$15,007	$700	$282	$982
7	$16,058	$700	$351	$1,051
8	$17,182	$700	$424	$1,124
9	$18,385	$700	$503	$1,203
10	$19,672	$700	$587	$1,287
11	$21,049	$700	$677	$1,377
12	$22,522	$700	$773	$1,473
13	$24,098	$700	$877	$1,577
14	$25,785	$700	$987	$1,687
15	$27,590	$700	$1,105	$1,805
16	$29,522	$700	$1,231	$1,931
17	$31,588	$700	$1,367	$2,067
18	$33,799	$700	$1,511	$2,211
19	$36,165	$700	$1,666	$2,366
20	$38,697	$700	$1,832	$2,532
21	$41,406	$700	$2,009	$2,709
22	$44,304	$700	$2,198	$2,898
23	$47,405	$700	$2,401	$3,101
24	$50,724	$700	$2,618	$3,318
25	$54,274	$700	$2,851	$3,551
26	$58,074	$700	$3,099	$3,799
27	$62,139	$700	$3,365	$4,065
28	$66,488	$700	$3,650	$4,350
29	$71,143	$700	$3,954	$4,654
30	$76,123	$700	$4,280	$4,980
31	$81,451	$700	$4,629	$5,329
32	$87,153	$700	$5,002	$5,702
33	$93,253	$700	$5,401	$6,101
34	$99,781	$700	$5,828	$6,528
35	$106,766	$700	$6,285	$6,985
Total		$24,500	$72,266	$96,766