Wednesday, August 15, 2007

How toxic are your corporate cash equivalents?

Many corporations carry a line item listed as “Cash Equivalents” on the balance sheet. By traditional definition, cash equivalents include U.S. government Treasury bills, bank certificates of deposit, bankers' acceptances, corporate commercial paper and other money market instruments.

As of 2006, corporate America has been sitting on record cash hoards.
Corporate America sitting on record cash stockpiles

Some large corporations such as Microsoft have over $20 billion in cash equivalents, placing them in a category where they are bigger then many fixed rate hedge funds. Cash equivalents of this size require an entire financial group for oversight and administration.

Earlier this year, the FASB proposed striking the term “Cash Equivalents” from corporate balance sheets in an attempt to improve reporting. Many companies have placed all sorts of assets into this column, some which may not be appropriate. The FASB wants to sort out items that should properly be defined as short term investments from true cash items.

FASB Moves to Nix "Cash Equivalents"

Corporations are regularly driven to seek the best yield on their “cash” stockpile. Many investment banks offered derivative products backed by mortgages that exceed the rate offered US Treasuries by a small percentage. Many of these products were hawked as being fundamentally safe from a risk perspective, and sold to pension funds, corporations, and other institutions.

The reality is that many of these bundled derivative products should have never been included under cash equivalents in balance sheets. Corporations do not fully disclose the cash equivalents that are held, so it is difficult for stock investors to get a sense of the quality of the holdings.

The recent liquidity crisis is bringing this situation to a head. There are probably a good number of corporate finance departments cringing as they re-evaluate their exposure to the CDO meltdown. Suddenly investments pushed by their investment banking partners have an entire new dimension of risk associated with them and are no longer “safe”.

This leads to the question – If the liquidity crisis continues will corporations have to re-state the value of their cash equivalents if any of the instruments held incur losses? What is the level of impact to the bottom line when these items are marked-to-market? How toxic are the cash equivalents on the books of America’s corporations?