Friday, October 17, 2008

The Balance Sheet as a Competitive Weapon

In finance, people talk about the "optimal" capital structure of the firm, i.e. the appropriate balance of debt and equity so as to minimize the cost of capital and maximize the value of the firm. However, some companies choose to maintain much less debt than they could afford to carry on their balance sheet. In fact, some firms not only carry little debt, but they maintain a hefty amount of excess cash as well. During good times, some investors dislike all that excess cash on a firm's balance sheet; they cite the opportunity cost, and they sometimes demand that the firm distribute the cash to shareholders through stock buybacks or dividends (sometimes because of fear that the management might squander the resources in pursuit of flawed diversification strategies or other ill-advised expansions).

Balanced against the opportunity cost, what does this conservatism get you, besides protection against financial distress during economic downturns? Most importantly, a strong balance sheet (low debt, excess cash) can become a competitive weapon for a firm. When other firms face distress, a company with a strong balance sheet can go on the offensive and put additional pressure on competitors. How can they do so? They might launch a price war, using the additional financial resources and flexibility to fund the discounting. That effort may enable the firm to increase market share in a downturn. They might also use the strong balance sheet to gobble up weaker competitors through mergers and acquisitions. Finally, they might use the resources to accelerate key investments in equipment, factories, R&D, and the like - investments that they know their rivals might not be able to match during the downturn.

Take the example of Wal-Mart in recent weeks. They just announced that they will be offering steep discounts on certain toys this holiday season. It appears that they are using their financial strength to try to increase market share at the expense of weaker rivals in the retail sector. Similarly, consider the examples of Wells Fargo and Bank of America in the financial sector. They appear to be using their strong balance sheets to make opportunistic acquisitions of weaker rivals during the financial crisis. These competitive moves would not have been possible without the flexibility provided by a strong balance sheet.

2 comments:

Kroywen said...

Yes, of course this is true. When evaluating a company in terms of its fundamentals, one first and foremost should look at its debt:equity and its cash holdings. Simply, lots of cash means the company is doing well. But I don't know if your post says anything about what the proper strategy is before or in anticipation of a credit crisis or financial disaster. Having a successful business - one that is profitable, in which the business is more risk averse than risk seeking - would allow it to weather the storm during a financial crisis because it would have a lot of cash on hand to strengthen its business or increase market share. But how does one effectively plan for such a maneuver without losing out on the opportunity costs in the lead-up to the crisis? If it doesn't plan efficiently, its strategy is completely conservative and risk-averse and possibly not nearly as profitable as it could be.

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