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One of the most basic ways to determine how sound a company's balance sheet is to determine how much cash they actually have. One simply has to read one of the company's official reports or can visit their favorite website to find, fairly quickly, how much cash a company has.

Most people would never say having cash on the balance sheet is a bad thing, but far too many think it is too much of a good thing. How can that be? A company lists their cash and that's how much cash they have. What could possibly be bad about that? The question really isn't if it's good or not, but how good is it really.

Problem #1: The Cash Isn't Really Theirs

Many companies believe it or not actually list cash on their balance sheet that isn't even theirs. If I let you borrow my pencil, technically it's yours for the time being. But is it really yours? Many companies are able to get away with this but the biggest violator is banks. Banks are able to list client deposits as cash even though the cash isn't really theirs. Again, having it listed isn't really a bad thing, but when looking over a company's fundamentals, they may not seem as great as they did once you factor out the cash that isn't theirs to keep. This can affect many key ratios investors use when analyzing stocks as well as the company's cash-per-share statistic.

Case Study: TradeStation

TradeStation (TRAD) currently trades at about a $200 million market cap but has an enterprise value of $-500 million! This is because the company has zero debt and $725 million in cash. The company could liquidate right now and you'd make a killing off just the cash distributions. Right? After a quick email with their CFO, an investor would be able to discover that almost all of that money belongs to their brokerage clients. It is almost untouchable when it comes to the company using it.

Problem #2: The Cash is Held Overseas

In most cases, the cash listed on a company's balance sheet is theirs to do with as they please. But at what cost? Checking to see where a company's cash is being held is extremely important. If a company is doing business in the US and wants to use their overseas funds in the US, they get an immediate 30% tax haircut on the transfer. If you are forced to take 30% of the cash off the balance sheet of your favorite company, is it still as strong? It's a critical thing to check.

Case Study: Pharmaceuticals

The top nine pharmaceutical companies in the US hold about $115 billion in cash. Problem is, many of these companies hold up to 75% of their cash internationally. Large deductions would be needed when evaluating Pfizer's (PFE) $26 billion cash hoard and J&J's (JNJ) $13 billion as well. J&J actually had to issue debt last year to make dividend payments because so much of their cash is held abroad.

Problem #3: The Cash Never Really Existed

The most obvious problem is when the firm lists cash that doesn't truly exist. This is much harder to spot that the others because obviously it's not disclosed, but a prudent investor should take the time to analyze a potential investment's balance sheet. With both Madoff and Enron, most people who spotted problems didn't know exactly what was wrong but they knew something just didn't add up. The saying holds true that if anything ever seems too good to be true, it probably is.

Source: Cash on the Balance Sheet: Not Always as Good as It Seems