Cash and liquidity management - Short-term investing and liq...

Learning Outcomes

After reading this article, you will be able to explain the objectives and principles of corporate cash and liquidity management, describe the purpose and components of liquidity buffers, and evaluate short-term investment options for surplus cash. You will also understand key risks associated with liquidity decisions and be able to apply these principles to exam scenarios.

ACCA Advanced Financial Management (AFM) Syllabus

For ACCA Advanced Financial Management (AFM), you are required to understand how organisations assess, preserve, and deploy liquidity, and the role of the treasury function in short-term investing. Revision for this area should cover:

• The objectives and policies of cash and liquidity management in the context of risk and return
• The practical tools for forecasting, monitoring, and controlling liquidity
• The rationale and calculation of minimum cash balances and liquidity buffers
• Evaluation and selection of short-term investment vehicles for surplus funds
• The role of the treasury function in managing liquidity risk and ensuring solvency

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which of the following is a key objective of liquidity management policy?
   1. Maximising long-term capital growth
   2. Ensuring funding needs are met as they fall due
   3. Investing all surplus cash in long-term assets
   4. Eliminating all business risk

2. What is a liquidity buffer, and why do companies hold it?

3. Name two major risks associated with short-term investing of surplus cash.

4. A company wants to earn interest on surplus funds but needs guaranteed access within 24 hours. Suggest one appropriate investment and briefly explain your choice.

Introduction

Cash and liquidity management ensures that an organisation has enough readily available funds to meet its payment obligations while avoiding unnecessary idle balances. The treasury function must continuously forecast cash positions, manage surpluses and deficits, and decide how much liquidity to hold as a buffer against uncertainty. Effective management reduces the risk of insolvency, controls borrowing costs, and maximises the return on surplus funds through prudent short-term investments. This article explains the principles of liquidity policy, the composition and sizing of liquidity buffers, and the main instruments for short-term investment, along with related risks.

Key Term: liquidity management
The system and process by which an organisation ensures it can meet its financial obligations as and when they fall due, while optimising the return on any surplus cash.

Key Term: liquidity buffer
The minimum pool of highly liquid assets or cash maintained to cover unexpected outflows or adverse scenarios, thereby helping to ensure solvency at all times.

Key Term: short-term investment
Placement of surplus cash in financial instruments with low risk, high liquidity, and maturity of less than one year, to earn a return while retaining quick access to funds.

Objectives and Principles of Liquidity Management

The main goal of liquidity management is to ensure that all payment obligations (such as payroll, supplier payments, interest, and tax) can be met on time. Insufficient liquidity can lead to service disruptions, penalties, reputational damage, or, ultimately, insolvency. However, holding excessive cash carries an opportunity cost—cash earns little or no return compared to other assets. The treasury function must strike a balance.

Key principles include:

• Maintaining sufficient, but not excessive, cash reserves
• Regularly forecasting cash inflows and outflows
• Monitoring actual versus forecast positions
• Investing surplus funds prudently
• Managing access to standby facilities (overdrafts, credit lines)
• Minimising the cost of funding deficits

Key Term: treasury function
A department or team responsible for managing an organisation's liquidity, funding, banking arrangements, exposure to financial risks, and short-term investments.

Liquidity Buffers: Purpose and Determination

Liquidity buffers are intended to absorb shocks such as unexpected expenditure, loss of expected receipts, or delays in funding. Regulators, credit rating agencies, and boards increasingly scrutinise the adequacy of liquidity buffers.

Sizing the buffer typically requires:

• Analysis of historical cash flow volatility
• Stress testing for adverse scenarios (e.g., large single payment, market closure, loss of a key client)
• Regulatory and internal policy requirements
• Commercial risk tolerance (risk appetite)

A basic approach is to set a minimum cash balance equal to the largest single-day net outflow in recent history, or to a multiple of expected daily outflows. More advanced models use statistical techniques or scenario simulations.

Liquidity buffers are generally comprised of highly liquid assets such as cash at bank and money market funds, rather than illiquid investments.

Worked Example 1.1

A company experiences recurring monthly cash flow swings due to payroll and rental payments. Management wants to determine its minimum cash balance. In the last year, the largest single-day net outflow was $1.2 million, and average daily outflow was $400,000.

Question:
How might the finance team justify setting a liquidity buffer, and what amount would be appropriate?

Answer:
A prudent liquidity buffer should at least cover the largest recent single-day net outflow, so $1.2 million could be justified. Alternatively, management could hold a buffer equal to 3 days' average outflows ($1.2 million), aligning with operational cash needs and providing a margin for error.

Managing Daily Cash Flows and Forecasting

The treasury team must prepare rolling forecasts of cash inflows and outflows, monitor bank balances daily, and compare actual to forecasted flows. Any anticipated deficit requires arranging short-term borrowing or drawing on available credit facilities. Anticipated surpluses can be placed in approved short-term investments.

Tools used include:

• Cash flow forecasts (daily, weekly, monthly)
• Bank account monitoring and reconciliation
• Variance analysis (actual vs. predicted)
• Regular communication with operational departments

Short-Term Investment of Surplus Cash

When forecast surpluses are identified, treasury selects appropriate short-term investments based on:

• Liquidity—how quickly funds can be accessed
• Security—risk of capital loss
• Return—interest or profit earned
• Matching—maturity with cash requirements

Instruments typically include:

• Bank deposits (call accounts, notice accounts, term deposits)
• Treasury bills
• Money market funds
• Certificates of deposit
• Repurchase agreements (repos)
• Commercial paper

Key Term: money market fund
A pooled investment vehicle offering daily liquidity, that invests in high-quality, short-term debt instruments and seeks to preserve capital and provide a modest return.

Worked Example 1.2

A company expects a cash surplus of $2 million for approximately 30 days. The finance manager wants low risk, daily access, and competitive yield.

Question:
Which investment is most suitable, and why?

Answer:
A money market fund meets all criteria: low risk, same-day settlement, and higher return than a standard current account. Alternatively, placing the funds in a 30-day notice deposit offers higher yield, but less flexibility if cash is needed early.

Risks and Controls in Short-Term Investing

The main risks of short-term investments are:

• Credit risk: The counterparty (bank, issuer) may default.
• Liquidity risk: Funds may not be immediately accessible.
• Interest rate risk: Falling rates may reduce returns.
• Market risk: Prices may fluctuate, especially for certain instruments.

Controls to manage these risks include:

• A written investment policy defining approved instruments, limits per counterparty, and minimum credit ratings
• Regular monitoring of counterparties' financial strength
• Limiting maturities to align with forecast liquidity needs
• Avoiding speculative or unfamiliar instruments

Key Term: credit risk
The possibility that a borrower or counterparty will fail to meet its financial obligations in full when due.

Short-Term Borrowing and Back-Up Facilities

Liquidity management also requires planning for temporary cash shortfalls. Tools include overdraft facilities, committed revolving credit lines, and short-term loans. The cost, flexibility, and speed of access are key considerations.

Worked Example 1.3

A company forecasts that it will run a cash deficit for three business days before a large receivable arrives. Its main bank offers an overdraft up to $500,000 at a daily rate. What should the treasury team do?

Answer:
The company should use the overdraft facility to cover the shortfall, ensuring the balance does not exceed the $500,000 limit, and repay as soon as the receivable arrives. This approach ensures commitments are met with minimal interest cost.

Exam Warning

The exam often tests whether surplus cash is being held in suitable instruments. Avoid selecting illiquid or high-risk assets for liquidity buffers or short-term working capital needs, even if their yield is higher.

Revision Tip

Regularly review the features, risks, and appropriate uses of short-term investment instruments. Practice identifying which assets are suitable for a liquidity buffer versus those for longer-term investment.

Summary

Sound cash and liquidity management enables companies to meet their obligations at all times, limits financial risk, and maximises the value of surplus funds. This is achieved by robust cash flow forecasting, setting and monitoring liquidity buffers, and prudent selection of short-term investments. Effective treasury policies and controls are essential to managing risk while allowing the company to respond confidently to cash volatility.

Key Point Checklist

This article has covered the following key knowledge points:

• The objectives and principles of cash and liquidity management policy
• The purpose, sizing, and composition of liquidity buffers
• Forecasting and monitoring daily cash flows
• Identifying and selecting appropriate short-term investment instruments
• Main risks associated with short-term investing and controls to mitigate them
• The function of back-up borrowing facilities for temporary cash shortfalls

Key Terms and Concepts

• liquidity management
• liquidity buffer
• short-term investment
• treasury function
• money market fund
• credit risk