Chapter Fifteen
,Managing Operating Cash and Investments
THIS CHAPTER OUTLINES THE USES of cash available to the company. There are different cash levels, and each has its own utility and purpose, based on which investment themes can be outlined. We discuss the management of operating cash and of investments beyond the immediate horizon, highlighting key principles and practices that could be of use while formulating tactics and strategies for the same.
DIFFERENT ELEMENTS OF CASH
Cash on the balance sheet can be divided by the Treasurer, based on need and longevity of expected stay on the balance sheet. The different elements of cash on the balance sheet are delineated in Figure 15.1.
FIGURE 15.1 Different Elements of Cash
From the cash available for use to the firm, the various elements are:
- Strategic or business cash
- Restricted cash
- Reserve cash
- Operating cash
Strategic or business cash is the long-term cash that is being kept for a specific purpose, such as an acquisition or capital payment. Here we assume that the cash that is not going to be required for an identified purpose or incident will be returned to the shareholders from the strategic or business cash.
Restricted cash is the cash that is in a particular location for a reason—say to support a financial transaction for the business (such as collateral) or as a consequence of doing business in a country (trapped cash).
Reserve cash is a buffer that is held to allow for forecasting variations and to use if operating cash is fully utilised.
Operating cash is the cash required to run the operations on a day-to-day basis. Because it is the most volatile type of cash, the need for planning, forecasting, visibility, and operational efficiency is greatest here. Because decisions on operating cash are made daily, it is important that there is time flexibility to make these decisions.
First we discuss operating cash, and then we cover the other types of cash.
MANAGING OPERATING CASH
As cash flows enter the financials and become cash (see Figure 15.2), the cash gets redeployed for various uses. From a day-to-day perspective, the working of the firm is managed through cash available hence operating cash is always kept for immediate use.
FIGURE 15.2 Operating Cash in the Context of the Balance Sheet
Because liquidity has to be almost immediate and visibility must be maximum for a geographically dispersed group with a large presence in emerging markets that have money flow regulations, it could be useful to manage operating cash locally, with some reserve.
From a process and banking capability perspective, it is important to have in place:
- Daily access to liquidity
- Transaction cutoff times for operations as late as possible to allow for more visibility
- Automation of investments and basic processes to allow for quicker turnarounds and more flexibility
Typical banking products used with operating cash include end-of-day sweeps into overnight deposits, demand deposits, or simply leaving the money in a current account, should a country have a minimum investment period for deposits.
Since liquidity is the prime driver of operating cash, investment return or interest received should take a backseat if the Treasurer has to prioritise.
Here we highlight the importance of short-term cash flow forecasting. If forecasts show less funds than is actually the case, there is an opportunity loss of funds that are obtaining suboptimal yields. If this forecasting error has been consistent, the Treasurer will consider lowering the operating cash required and moving the excess to any other cash element. If, in contrast, the forecasts show more funds than is the actual case, the Treasurer will always be dipping into the reserve cash pool or borrowing from the local markets, as required, which may not be optimal for the firm. Thus, the Treasurer must set the levels of each cash element after examining the actual requirements, historical performance, and forecasting accuracy.
The currencies and entities with which the money is being placed or invested are also important drivers in the process. Similar processes and monitoring will have to be followed as indicated in the process for investments that we explore later in the chapter.
SURPLUS CASH AND INVESTMENTS
The three elements of cash that are not to be placed with immediate liquidity—reserve cash, restricted cash, and strategic or business cash—are grouped under the name “surplus” cash and generally are invested with both tenor and liquidity in mind.
Reserve cash is effectively the excess balance from forecasts to cover exigencies in day-to-day variations and account for investments with very short term liquidity (up to three days or a week maximum). When a large inflow does not come in or a sudden unforecasted payment has to be made or a forecasted payment advanced, reserve cash is the first source that the Treasurer turns to on falling short of operating cash. This requires high flexibility to draw down when required. Accumulated or continuously excess forecasts can lower the reserve requirement. The Treasurer can move these funds to strategic cash over time or return the money to shareholders, should the minimum amount for other elements be met.
Restricted cash can be either trapped cash (cash trapped in regulated jurisdictions or countries where attempts to repatriate cash face tax-unfriendly situations) and collateralised cash. The Treasurer looks for opportunities to use restricted cash in a net borrowing at another location and in doing so, get these funds set off from the balance sheet. Hence, while waiting for windows of opportunity to invest in the same country or repatriate back to the parent, the Treasurer will seek to optimise returns over time and also manage the currency aspect since the money is likely to be held in a local currency in that country.
Strategic or business cash is the cash that is held for an anticipated medium-term use, such as an acquisition, capital payment (buyback, prepayment, etc.), or dispute settlement. If the event does not take place, shareholders will expect the money to be paid back to them. Hence, a chief executive officer and chief financial officer will have to be very sure of the strategic cash being held when defending the strategy to the board and shareholders.
CONSIDERATIONS AND ASPECTS OF INVESTMENT DECISIONS
Figure 15.3 provides some of the aspects and considerations of investment decisions.
FIGURE 15.3 Investment Decision Considerations and Aspects
We discuss each of the considerations in detail. The term issuer is a generic term for the entity that accepts the investment or with whom the final investment is made. This could include a bank accepting a deposit.
Drivers
The key objectives and motivations behind the investment decision have to be reviewed in detail. They could be principal protection, returns, benchmarks, or tenors and end use.
Principal Protection
One definition of principal protection is that in any scenario, on maturity, the investor gets back, at minimum, the principal amount initially invested in the initial currency of investment, even if the interest or return paid is zero.
One of the underlying risks assumed is that the investee or deposit taker is solvent and can pay back the deposit or investment at maturity. However, if the deposit or investment is linked to the credit of another party (credit-linked note), and there is a possibility on paper that the investor will not get back 100% of the invested amount, the note is not principal protected.
All investments for companies with a conservative approach should be principal protected. Structured investments (outlined later in the chapter) are any nonvanilla investments that have a payoff that is variable, other than a simple floating rate.
The other important aspect of principal protection is the currency of investment. The principal returned must, at the time of maturity, be at least equal to the principal originally invested and in the same currency. Some interesting products, such as dual-currency deposits, claim to be principal protected, but in some scenarios they pay out the principal in a different currency from the invested one. When converted back to the original currency at maturity, the investor could be surprised to find that the amount could be lower.
The box below provides a peek into the mechanics of a simple principal protected structured investment.
FIGURE 15.4 Sample Principal-Protected Structured Investment
It is important to evaluate principal protection in all scenarios prior to making an investment decision. Buying equities outright, for example, does not ensure principal protection; buying a simple bond and holding it through to maturity does ensure principal protection, provided the issuer does not default.
Liquidity
Investment liquidity is the ability to immediately convert the investment to cash. This is an important objective for most investors, especially corporate treasuries, and is covered more in the section on liquidity risk and in Part Four.
Returns and Benchmark
In conservative situations, the return objective should be lower in priority than principal protection and liquidity.
Returns have to be quantified in annualised terms and measured with respect to the original currency of investment or in terms of the base currency of the company at a consolidated level. It is critical to evaluate the payoff profile of an investment under all scenarios.
Also, if the payoff is exceptional, and much better than a simple market investment for that tenor, the investor should look at the payoff again: What is it that is being given up?
As Milton Friedman said, there is no such thing as a free lunch. In order to make a probabilistic return that is much better than the market, some risk is being taken. The only scenarios where returns can be locked in for minimal risk is arbitrage, and in today’s global markets, many practitioners come in to reduce and eliminate arbitrage almost as soon as it is created.
Depending on the objectives of the investments, these returns can be measured against a benchmark, an internally fixed budget or simply from the perspectives of principal protection, availability, and liquidity.
Tenors Determined by Cash Elements
Tenors are determined by the elements of cash that are being invested. For operating cash, the timelines have to be overnight or on demand, at best. For strategic or business cash, tenors can be a little longer.
Callability is a feature that has become quite popular. When an investment is callable, the bank or issuer has the ability to call the investment back and pay the cash with returns back to the investor at points before maturity. For this option, the issuer pays the investor a better return. The investor must realise that the incremental return is effectively the price of the option that the investor has sold to the issuer. What should the tenor of this investment be? To mitigate interest rate or rollover risk (discussed in Part Four), the investment must be treated as the lowest possible tenor: that is, getting the money back when rates have moved lower. From a liquidity perspective, conservative investors should take the tenor of the investment as the maximum or maturity period, since it must be assumed that the investor will hold on to funds in a period of tight liquidity, thereby locking in the amount for the full tenor.
Risks
We explore the various risks in Part Four of this book. Here we highlight some of the important points.
Market Risk
Market risk is the risk that the instrument or investment payoff will change with a change in market factors (e.g., foreign exchange, interest rates, commodities, etc.). For a note linked to credit-derivative prices, the movement of the credit default swap spreads related to the note can also be defined as a market risk.
Credit Risk
Credit risk is the risk that the issuer will not be able to pay back the investment principal and returns at maturity. One aspect to consider here is leverage, where an investment is taken back as collateral to fund further investments in the same note. This is not a conservative investment practice; while it increases returns substantially on theoretically the same market elements, it also introduces borrowing elements that have to be accounted for.
Liquidity Risk
Liquidity risk is the ability to generate cash from the investments at any point of time. The liquidity of the market, i.e., the ability to sell or liquidate the investment in the market or with the original or different counterparty at immediate notice, is a critical determinant of the investment itself. We cover liquidity risk and its measurement in detail in Part Four.
Tools
There are various investment tools, and we classify them into type or instrument, asset classes, and diversification.
Instruments
Some of the various instruments are:
- Current account balances across currencies
- Outright purchases of equities or commodities
- Bank deposits: demand or time
- Structured deposits
- Government securities (bills, bonds)
- Commercial paper
- Corporate or institutional bonds
- Notes from issuers
- Funds
- Derivatives such as options
The various payoff types include:
- Fixed rate
- Simple floating rate
- Structured
A vanilla investment is one that has a simple fixed rate or a simple floating rate directly linked to a regular benchmark. A structured investment is one that has a payoff derived from some market factor or has some feature (variability of return, currency of investment, variability of maturity, etc.) that differentiates it from the vanilla payoff.
Structured investments generally have some embedded derivative or similar transaction that provides the payoff and that is different from a normal investment. Accounting for structured investments is more complex than accounting for simple products, and the controller must be involved in determining the applicability of these products to the group.
One golden rule that has worked for many companies is not to invest in any product that they themselves cannot price or break up. The more complicated the product, the more opaque its pricing generally is, and the greater the risk if the markets move against the investor.
Asset Classes
The various asset classes or investment classes available to the investor are:
- Equity
- Debt (fixed income and money market)
- Credit
- Foreign exchange
- Commodities
- Hybrid (combination of these)
- Funds (Today funds are a separate asset class by themselves, owing to different and varied products, including private equity, hedge funds, mutual funds, etc.)
- Real estate
Diversification
Diversification, also covered in detail later in the book, is the spreading of risk (in this case, investments) through conscious analysis, backtesting, view taking, and planning into separate currencies, instruments, issuers, locations, asset classes, and payoff profiles, with the expectation that the mean return will provide the least loss and the most optimal return.
Diversification is employed by companies in manners ranging from the simple (holding current account balances in a few currencies) to the complex (having a very diversified portfolio across the various parameters mentioned earlier).
Infrastructure
The infrastructural aspect of investments, which must be captured across Treasury and accounting policies and operational procedures, are important to get the end-to-end process of investing correct. The infrastructure must be well equipped to handle the volumes, complexity, turnarounds, and products used in the investment. The various components of the infrastructural aspect of investments are:
- Accounting
- Control
- Monitoring
- Operations
- Compliance
- Valuation
- Evaluation
INVESTMENT PROCESS
Figure 15.5 depicts a simple flowchart for the investment process.
FIGURE 15.5 Investment Process Flow
The first step is to define the objectives and the scope of the investment process. For each subsidiary, entity, and jurisdiction, the elements of cash across operational, reserve, restricted, and strategic/business cash are identified and set, along with time horizons of each. The drivers of the investment are then decided—the primary drivers and secondary, if any.
The second step is critical: tie up the investment process with the risk management process. The two should be aligned, since the investment aspect is one part of the overall risk management of the firm, and any action taken on investments will impact the risk profile of the company.
The roles and responsibilities across all areas, including remote decision makers, have to be identified and documented. Responsibility for control, operations, and monitoring also has to be implemented, and can ride on the same infrastructure as the entire Treasury.
The instruments, with descriptions and allowable elements, have to be defined in order to meet the objectives and tenors identified earlier.
For the various elements of cash we discussed in Figure 15.1, operating cash can use the simplest of instruments. For reserve cash, we can explore some other alternatives, such as money market funds, time deposits with sweeps, or short-tenor notes including commercial paper. For restricted cash, locally available instruments or those as determined by the collateralisation agreement would restrict what can be done—hence, tenor could be one area that could add value. In some more adventurous situations, the Treasurer could look at other fixed income structured instruments or notes, bond funds, or even diversification and credit-linked structures that could provide funds to be used in another location through the use of a financial institution’s balance sheet. Finally, for strategic or business cash, longer-tenor principal-protected instruments could be explored, as could be diversification or structured notes in other asset classes.
The execution parameters are also defined—limits on counterparty, type of instrument, market factor, tenor, amounts, and so on are all decided and put in place. Mechanisms to track these parameters also should to be implemented. The payoff profile of each investment should be examined and approved, in the case of structured investments.
Finally, the investments have to be monitored and evaluated done. This can be similar to the evaluation process for risk management described in Part Four.
SUMMARY
Investments and use of cash remain among the most important aspects of the treasurer’s scope of operations. Geographic diversity, increasing market volatility, and business uncertainty cause the management of investments and cash, especially operating cash, to become an extremely challenging task.
In this chapter, we examined the different elements of cash and how a Treasurer can treat cash differently.
We focused on operating cash, which, because of the imminent liquidity and availability aspect, has to be dealt with differently from other elements of cash. We also looked at various aspects of investment management and concluded with a simple process of investment, which has to be aligned with the firm’s overall risk management.