Treasury Today Country Profiles in association with Citi

Cash segmentation and investments

Coins spilling out a piggy bank vase

A successful treasurer is one who achieves a good balance between investing excess cash and delivering the necessary cash resources to support company liquidity. In this article, we look at how categorising cash into separate portfolios enables consideration of the risk/return profile necessary to meet the company’s liquidity requirements.

Getting the most out of cash investments while maintaining company liquidity is challenging at the best of times; and even more so when the markets are volatile. There is no easy way to achieve the right balancing act, but it is prudent to adopt an organised approach to it by ‘tranching’ the cash according to its type. Tranching describes the process of investing cash in line with its characteristics (especially its time horizon) and the risk/return profile the company is seeking.

Defining corporate cash buckets

To achieve this, a corporate must first decide on and define the categories that its cash will be divided into. For many corporates the most beneficial, and logical, way to categorise cash is by time periods. It is therefore common for the buckets to be defined by the short, medium and long-term cash requirements of the business. However, all companies have their own individual needs, so extra layers of complexity can be added. For example, sub categories based around currency and location of cash, can be developed to better reflect the needs of the company.

Despite this, corporates will tend to keep things simple and segment their cash into:

  • Operating cash/working capital (short-term).

  • Reserve cash (medium-term).

  • Strategic cash (long-term).

Let’s take a closer look at what defines each of these categories.

Operating cash (short-term)

Operating cash is the lifeblood of a company, allowing it to meet its day-to-day obligations such as working capital, salary and interest payments. In most cases corporates will plan for this cash out to three months, although some companies may extend this out to a year depending on their circumstances. How this cash is used may be subject to unexpected fluctuations, as the demands of the economic environment put pressure on the daily ebb and flow of the business. As such, treasurers will want this cash to be easily accessible and secure.

Reserve cash (medium-term)

Reserve cash, otherwise known as core cash, is used to meet the medium-term business needs of a company, typically from a time period of three months out to one year. It is often used for but not limited to: dividend payments, tax obligations and can also be used for planned business expansion such as mergers and acquisitions (M&As). Reserve cash will not need to be as liquid as operating cash, however it would be useful for the treasury to be able to access this in a timely fashion, should market conditions necessitate.

Strategic cash (long-term)

The final core bucket of cash is strategic cash. Unlike operating and reserve cash, this segment has no immediate use for the business within the next year and further out – the exact timeframe needs to be defined by the company. This cash may be used to fund future, as yet unplanned M&A activity, spent on internal development projects, or eventually be returned to shareholders. Strategic cash could also be used in a precautionary capacity, should market conditions take a turn for the worse.

Although forecasts still tend to be less accurate than most treasurers would like them to be, they do (or should) provide a realistic view of future cash resources and therefore provide an early opportunity for identifying potential surplus cash.

Ups and downs

The graph opposite illustrates the peaks and troughs in a company’s cash position and illustrates two occasions where it needed to dip into its reserve cash in order to meet its day-to-day obligations. Of course, the aim is for this never to happen, however, at times when business performance takes an unexpected downturn or market conditions change this may be needed. Yet a tool is at hand to ensure that the treasury can best plan what cash is needed and when – the cash flow forecast.

Looking into the crystal ball

Cash flow forecasts show a company’s expected net cash positions from its operating, investment and financing activities during a specific period, based on known commitments and receipts, with appropriate adjustments being made (using historical data, trends and/or statistical techniques) to allow for future variables.

These forecasts are the ultimate source of information for determining the amount of cash available, where it is and when it will be required. Although forecasts still tend to be less accurate than most treasurers would like them to be, they do (or should) provide a realistic view of future cash resources and therefore provide an early opportunity for identifying potential surplus cash (as well as deficits) and other essential information such as:

  • Currency denomination.

  • Present location.

  • Total amount (value) available.

  • Planned future location (and currency).

  • Time horizons (ie the length of time cash will be available for investment before it is needed by the business).

In addition, the forecasts will help treasury to define how ‘important’ the cash is to the business’s daily operational activities and what the impact would be on the company if the cash to be invested was not readily available to meet day-to-day obligations, eg would trading be severely affected?

Figure 1: Cash position of a non-financial corporate over time
Figure 1: Cash position of a non-financial corporate over time

To assist with cash segmentation strategies, cash flow forecasts are also complied in different time horizons. Typically these will be short-term, medium-term and long-term time horizons, matching the corporate cash buckets:

  • Short-term.

    Short-term forecasts provide the cash detail needed to help manage working capital and to protect day-to-day company liquidity, covering the immediate cash inflows and outflows that affect overnight balances. Daily and even intra-day forecasts ensure that treasury keeps abreast of last minute changes to cash flows. Weekly and monthly forecasts (for up to about three months) provide advance warning of the expected cash positions.

  • Medium-term.

    Rolling monthly forecasts for up to 12 months ahead help to predict cash needs and surpluses further into the future. They help to show where the high and low points of cash availability are likely to occur through the course of the year as well as identify when existing investments and debts may be maturing.

  • Long-term.

    Long-term forecasts may cover up to a three or even five-year period. They provide a longer view of potential surplus resources and financing needs to help ensure that a company’s business plans and strategies can be properly funded. They also help to identify future cash that has not yet been ‘earmarked’ for use and is therefore available to invest for a longer time period.

So, cash flow forecasts provide a good understanding of the peaks and troughs in cash availability across the group. They help to identify the type of cash available to invest, the criticality of that cash and accordingly, the amount of cash that can be allocated to each cash category. By frequently monitoring these forecasts, the cash allocations within each cash category can be suitably adjusted to ensure that their levels remain pertinent for meeting business needs. As each cash category will have different characteristics, they will also have different investment objectives and therefore be invested in different types of instruments. This means that they will be tranched differently.

As each cash category will have different characteristics, they will also have different investment objectives and therefore be invested in different types of instruments. This means that they will be tranched differently.

Investment decisions

Investment decisions for each cash category should be guided by the degree of priority given to the three main investment objectives. These objectives are:

  • Security

    Minimising the potential risk to the original sum invested (the principal).

  • Liquidity

    Ensuring timely realisation of the cash.

  • Yield

    Achieving the best possible return on the cash.

The type of investment instrument used will depend on the risk it exposes to the cash versus the potential return it offers (its risk/return profile). Therefore, for each cash category, the mix of instruments permitted, their limits and any restrictions will need to be balanced with the priorities given to the investment objectives. The aim is to identify and invest in the instrument types which offer the best and most appropriate investment opportunity for the cash.

An instrument offering more security and greater liquidity will usually deliver less return. So, for example, whilst such an instrument may be appropriate for investing operating cash, a treasurer may be prepared to assume more risk for better yield on money available for a longer period. Information relating to investment objectives and instruments should be detailed for each cash category within the investment policy and guidelines. It is important to be clear about how each of the categories must be treated.

Information relating to investment objectives and instruments should be detailed for each cash category within the investment policy and guidelines. It is important to be clear about how each of the categories must be treated.

Investment by category

Now we will look more closely at the three example cash categories we mentioned earlier and consider how they may be treated from an investment perspective. Individual companies will, of course, have different requirements and will identify and adapt the use of instruments to meet their own business challenges. It is imperative that all investment decisions are fully supported by judicious research and understanding of the counterparties, markets and investment instruments to be used.

Operating cash (short-term)

Liquidity and security is the key for any investment instrument involving operating cash, yield is a nice to have but not a must. As such, treasurers will tend to look to invest in overnight accounts, money market funds (MMFs) or other instruments that offer access to cash after a short-time period determined by when the cash is needed. These products typically offer a low, but steady yield. Investments in fixed income instruments are generally avoided when investing operating cash unless there is a highly liquid secondary market or extremely short maturity date.

As treasurers are acutely aware after the financial crisis, in order to limit the counterparty risk, diversification of funds is of great importance.

Reserve cash (medium-term)

When looking to invest its reserve, or core cash, treasurers can begin to look at some more exciting investment options, including reverse repos and short-term bond funds, as well as high quality corporate debt. All of the investments instruments listed under operating cash can also be used but treasurers can also look to seek more yield whist affording proper protection of the original sum invested in order to meet expected obligations. Since the financial crisis, security has been the primary requirement for this cash, with yield being second. Due to the medium-term nature of this cash, high liquidity is not of paramount importance. It is worth noting however, that this order may change depending on the risk appetite of the business and the market conditions it is operating in.

Strategic cash (long-term)

Finally, the strategic cash bucket is where treasurers have historically become more creative in their investments in the search for improved yield – but, accordingly, this will expose the cash to greater risk. The investment will have to ride greater volatility in the markets with a higher possibility of the cash principal being eroded. It is therefore important to ensure that investments can be maintained for the long term in order to overcome possible short-term turbulence in the markets. As with other cash categories, cash should be diversified across different instruments.

The treasury may invest in similar instruments that its reserve cash is invested in, but that return slightly higher yield. It may use instruments such as floating rate notes, or invest directly in equities – but the gain from these is generally achieved through investing for the very long term.

A tough environment

Whilst the above outlines how segmented cash might be invested in a perfect world, as treasurers are all too aware the current environment is far from ideal. It comes as little surprise to learn then, that, according to data from Bloomberg, European corporations were sitting on cash balances just short of €2 trillion in April 2014. This phenomenon is not restricted to Europe, however. Asian companies too have often been criticised for hoarding their cash and recent data has shown that Japanese corporates for example have around $3 trillion on their balance sheet. Thomson Reuters data also shows that China’s 500 biggest companies have $405 billion stockpiled.

For most companies, a large portion of this cash is being used as a liquidity buffer against external shocks, but many corporates are also struggling with the concept of low or even negative returns, as well as the impact regulatory change in the MMF sector. As such, the treasurer’s job is becoming increasingly difficult. And as market conditions continue to change, so will the parameters of corporate cash management – and the different requirements and priorities for investments. Regular reviews of cash and investment positions, exposures and policies are therefore recommended.