Effective interest rate management can increase the return on a cash surplus | |
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Many companies are holding record amounts of cash. Owing to the current low level of interest rates, however, the return on cash is not very attractive.
Corporate profitability has risen.
Since the bursting of the Internet bubble, companies have been cleaning up and then strengthening their balance sheets.
They have been working to improve their overall balance sheet structures, starting with repaying or reducing debt by selling off unprofitable assets. Companies are now focusing more on the core activities that offer the highest added value. They are also making increasing use of outsourcing, which can frequently result in cost savings.
Other techniques are also being used to improve liquidity, for example, by paying stock dividends rather than cash dividends. Finally, companies are less inclined to make overpriced acquisitions than was the case during the recent boom period.
Against a backdrop of fairly weak economic conditions, an uncertain global situation and market shifts (enlarged EU 25, delocalisation, and the rapidly growing economies of the Far East), companies have become more cautious. They view large cash surpluses primarily as a financial buffer against losses, and as a cushion for any remaining indebtedness. What cash reserves also give them, however, is additional scope for investments and/or acquisitions.
Research has shown that companies with a high long-term cash position tend to be risk averse. However, it is not necessary to hold excess cash reserves and to do so may even have negative consequences; it is not viewed favourably by investors or market analysts and may subsequently cause a fall in the company's share price. At the same time, excess cash reserves make a company a more attractive takeover target.
Three-phase interest rate management plan
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A cash rich company should invest its cash surpluses since the current return on cash is not very attractive owing to low interest rates.
The following three-step plan will help you to maximise the return on cash surpluses.
1. Cash management
How much cash is there? Where is this cash (in this country or abroad, in one or more accounts, which currency is it in; working capital often also includes a core amount of surplus cash. Is the existing cash management adequate (debtor management, pooling, ...)?
2. Cash forecast
Why is the cash being held? How long will the surplus be available? Is it being used as security for a loan? Has a cash flow forecast been drawn up? This will give an immediate picture of the investment horizon.
3. Simulations
The company should draw up a number of scenarios based upon the answers to the questions above, comparing the return on cash management today with the potential higher return on other products.
Overview of possible solutions for a term of less than one year
Fortis Bank can offer its customers various ways of improving the return on their cash surpluses.
Companies generally look for solutions in the simplest products that offer the highest return without risking capital. These tend to be business deposit accounts and fixed-term deposits. A fixed-term deposit is a simple and transparent instrument for investing funds in euros or foreign currencies on a short-term basis and generates a reasonable return.
Commercial paper and structured products frequently offer a better return, however, and they are not only intended for large corporates and institutional investors.
Commercial paper is a short-term bearer debt security issued by a company or a government body. Commercial paper is a fairly new financial instrument in the European market, but its use is growing steadily. The spread on commercial paper is wider than on deposits, but commercial paper is not risk-free. The higher the return, the higher the risk.
Structured products and derivatives are instruments that are widely used by financial institutions and institutional investors, but they can also be used by companies. The minimum amount is inversely proportional to the term. For example, for a one-month term, based upon an option on an exchange rate, the minimum amount would be EUR 2.5 million.
Fortis also has expertise, solutions and investment formulas for longer-term treasury investments, and can advise on the risk/return trade-off of issuing corporate bonds.
