Explain how a firm handles its cash and marketable securities
The idea
Cash management balances three objectives that pull against each other: safety of principal, liquidity, and yield. Operating balances must be available on demand, so they sit in instruments where the first two dominate and yield is almost incidental. Reserve balances held against contingencies can accept slightly longer maturities. Investment balances not needed for a known period can reach for yield. The characteristic failure is reaching too far — buying instruments that are liquid in normal conditions and illiquid in a crisis, which is exactly when the treasurer needs to sell them.
A practice question
What is the primary objective when investing a company's operating cash balance?
- Maximising the yield on the balanceWhy not: The objective that gets treasurers into trouble. Operating cash has to be there on the day it is needed.
- Preserving principal and keeping it liquid — correct
- Diversifying across several asset classesWhy not: A portfolio objective. An operating balance is not a portfolio and is held for a specific near-term purpose.
Operating cash must be there when payroll falls due. Yield is a distant third consideration for balances that are genuinely needed at short notice.
A harder one
Why might a treasurer hold instruments of differing maturities rather than all overnight deposits?
- To match maturities to when the cash is actually needed — correct
- Because overnight deposits are prohibited above a thresholdWhy not: No such prohibition exists.
- To reduce the company's overall tax liabilityWhy not: Interest is taxable whatever the maturity; laddering is about matching cash needs and picking up some yield.
Cash is not one pool: some is needed tomorrow and some not for months. Matching maturities to need earns yield on the latter without risking the former.
The hardest tier
What is the characteristic danger of reaching for yield in a corporate cash portfolio?
- Yields on short-dated instruments are always negative in real termsWhy not: They are usually positive, and the danger is not the level of the yield but what is given up to obtain more of it.
- The instruments become taxable at a higher marginal rateWhy not: Tax treatment does not deteriorate with the reach for yield; liquidity does.
- Instruments liquid in normal times become unsellable in a crisis — correct
Liquidity is a property of market conditions, not of an instrument. A treasurer who needs cash in a stressed market discovers the difference at the worst possible moment.
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