Joel Greenblatt's Magic Formula® Investing (NASDAQ:MFI) strategy relies on two and only two metrics: pre-tax earnings yield (EBIT/EV) andreturn on tangible capital. The first finds companies with stocks selling at a high return on their earnings, the second finds companies that generate high returns on the capital they invest into their business. Put it together, you get "cheap stocks of good companies". Sounds like a good way to invest.

MagicDiligence has attempted to generate a close approximation to these two statistics with the statistics calculator, which you can run any non-financial stock through. It gives you the earnings yield and return on capital figures and tells you whether they look good or not. Additionally, and more to the point of this article, it provides a detailed breakdown of the calculations used to achieve those figures.

One of the most common questions asked on those figures is the calculation of "excess cash". In this article, I'll try to explain what exactly "excess cash" means, why the seemingly confusing calculation makes sense, and why it is important to the calculation of MFI statistics.

So let's start with the obvious question: what does "excess cash" mean? All companies carry at least some cash and equivalents on their balance sheet. This is liquid capital that can be deployed to meet short-term obligations, pay dividends, buy back stock, make acquisitions, etc. Many firms also carry short-term investments, usually instruments that pay a little higher interest rate but are still fairly liquid. For our purposes, we just group the two together and call it "Cash" in the calculator, because they are essentially the same thing.

Cash isn't really invested capital used to generate the company's revenues and profits. Invested capital is a firm's physical plant (buildings, factories, computers, etc.), inventory, and so forth. So we shouldn't consider extra cash when calculating invested capital - it should be subtracted out.

Likewise, cash acts as a discount on the purchase price of the company. For example, say you were going to buy a company for $1 billion dollars, but that company had $250 million in cash in the bank (and no debt). In essence, you are only paying $750 million, because once the acquisition was complete, that $250 million in cash replenishes some of what you spent. This is why we subtract cash out from the enterprise value, the "EV" part of the EBIT/EV earnings yield calculation.

**Excess Cash**

Now that we've established the value of cash to a business, let's talk about what "excess" cash means. We will use a real-world MFI example: drug distributor AmerisourceBergen (NYSE:ABC).

AmerisourceBergen lists $1,656 million in cash on their balance sheet. We mentioned earlier that one common use of cash is to meet short-term business obligations. These obligations are listed in the "current liabilities" section of the company's balance sheet. For ABC, they list obligations of $9,171 million for paying suppliers ("accounts payable"), $482 million for paying employees ("accrued expenses"), $906 million for upcoming tax payments ("deferred income taxes"), and $392 million in debt coming due, for a total of $10,951. If we subtract those from cash available, ABC comes up with a massive shortfall of cash!:

Excess Cash = $1,656 - $10,951 = -$9,295

This is far too dramatic. Current cash is not the only thing that will be used to cover these liabilities - current assets are expected to be turned into cash over the same period of time (one year). So we should subtract those from current liabilities. Note that "current asset" calculations include cash, so we need to subtract the cash part out first:

Non-Cash Current Assets = (Current Assets - Cash) = $11,170 - $1,656 = $9,514

Excess Cash = -$9,295 + $9,514 = $219

AmerisourceBergen has about $219 million in "excess cash" that it doesn't need to help cover current liabilities. This is the money that can conceivably be used to pay dividends, buy back stock, invest in acquisitions, etc. - in addition to ongoing free cash flow. From the above, we get the below equation for excess cash:

Excess Cash = Cash - Current Liabilities + (Current Assets - Cash)

In the stats calculator, it is expressed a little differently, but you still get the same result since cash is a component of current assets:

Excess Cash = Cash - (Current Liabilities - Current Assets + Cash)

Finally, we want excess cash to be a positive number. It is conceivable, although relatively rare, that current liabilities out-strip total current assets. We guard against this by putting a maximum of 0 on the value to subtract from cash:

Excess Cash = Cash - MAX(0; (Current Liabilities - Current Assets + Cash))

This figure is then used to calculate the enterprise value and invested capital. Remember, we only want to subtract excess cash from the invested capital, because the portion of total cash needed to cover current liabilities is an investment in the company!

**Wrapping Up**

The concept of "excess cash" is important to understand when studying the MFI strategy. It is an efficient way to get to the core of just how much extra cash a company has on their balance sheet, and accounting for that extra cash both in valuation and in efficiency metrics. The seemingly confusing calculation becomes fairly straightforward when the concept is presented in example.

Steve owns no position in any stocks discussed in this article.

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**Disclosure: **I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.