Liquidity Management in Treasury

Written in cooperation with Aviva Investors

Liquidity is the lifeblood of a company, as all treasurers well know. Indeed, managing liquidity is a day-to-day job for all treasurers and their teams. In many cases this will mean extensive interactions with banks. While clearly both necessary and potentially beneficial, there are other options to consider. In this article, we will set out some of the opportunities available to treasurers.

But first, a definition

Liquidity management in treasury involves the strategic planning and control of cash flows to ensure that a company maintains sufficient liquid assets to meet its short-term obligations. This process requires treasurers to closely monitor and manage the inflow and outflow of cash, relative to their stock of liquid assets and cash to hand. Too little cash can be disastrous; too much, on the other hand is a “high quality problem” to have.

Effective liquidity management is crucial for several reasons. First, it ensures a company can meet its financial obligations, such as paying suppliers, employees, and creditors, without disruption. This promotes financial stability and operational continuity. Additionally, maintaining adequate liquidity helps companies avoid costly borrowing or emergency financing, which can negatively impact profitability. Proper liquidity management also enhances a company’s creditworthiness and investor confidence, as it demonstrates prudent financial stewardship and risk management.

Objectives of liquidity management

The key goals

The primary objectives of liquidity management in treasury include ensuring solvency, optimising cash utilisation, mitigating risk, and enhancing profitability. Ensuring solvency involves maintaining enough liquid assets to meet short-term liabilities and obligations. Optimising cash utilisation means efficiently managing cash flows to minimise idle cash and maximise returns. Mitigating risk involves reducing the risk of liquidity shortages that can lead to financial distress or insolvency. Enhancing profitability involves balancing liquidity needs with investment opportunities to achieve optimal returns on surplus cash.

Liquidity management aligns with broader company objectives by supporting financial stability and enabling strategic initiatives. For example, maintaining sufficient liquidity allows a company to invest in growth opportunities, pursue mergers and acquisitions, and navigate economic downturns. By optimising cash utilisation, companies can improve profitability and shareholder value. Additionally, effective liquidity management contributes to a strong credit rating, which can reduce borrowing costs and enhance access to capital markets. It’s worthwhile noting that most rating agencies factor both cash and money market funds into their cash definitions, which also feed into downstream metrics e.g. net debt.

Balancing liquidity needs with investment opportunities

The foundation: a robust treasury investment policy

A treasury investment policy provides a framework for managing an organisation’s investments. In most cases, it will seek to preserve capital through rigorous risk management, ensure liquidity, and generate a competitive yield.

Clearly-defined objectives and scope are essential for a well-developed treasury investment policy. Most treasury investment policies identify preserving capital, maintaining liquidity, and generating yield as the primary, stated objectives. Policies can be more or less granular in determining the scope, in terms of eligible assets and investment strategy. A well-developed policy will identify key personnel involved in investment decisions. This will typically feature the treasury manager, investment committee, and board of directors. Approval processes outline the approval processes for investment activities to ensure proper oversight and accountability. In Aviva’s Investors‘ view, best-in-class policies feature periodic policy reviews, such as every three years, to ensure the overall policy remains relevant over time.

An investment policy statement details the specific objectives of the treasury investment portfolio in terms of risk, time horizon, and yield or return aspirations relative to the cash sources and uses of the entity. The investment policy statement should also outline the governance structure, including roles and responsibilities, approval processes, and periodic policy reviews. This ensures that the policy remains relevant and effective over time.

Turning policy into practice

The core components of a solid treasury investment policy may be comparable across businesses, but the application of those policies can vary widely. For example, the treasury investment needs of a retailer with significant seasonal cash flows in the fourth quarter of each year have a materially different profile from an infrastructure entity with highly predictable and stable cash flows.

Determining how to turn the policy into practice needs a rigorous assessment of cash sources and needs. Cash flow forecasting techniques can be a significant driver of cash investment decisions, as can scenario testing. The former involves implementing robust techniques to predict cash flows accurately and plan accordingly.

For example, looking at seasonal historical trends and adjusting for known or planned cash in/out flows. The latter involves assessing the impact of different market conditions on liquidity and investment opportunities. It’s worthwhile reminding ourselves that we have witnessed real-life stress cases in the recent past. The impact of Covid-19 on hospitality business cashflows was stressful in the extreme, with cash receipts falling to near zero overnight, while cash outlays were much less elastic to the change in cash inflows. Maintaining a liquidity buffer in case of unexpected events is prudent.

For a deeper dive into these practical strategies, see the Aviva Investors Liquidity Optimisation resource.

Matching cash management needs to available instruments

A simple categorisation of cash flow predictability can help guide instrument choice:

Where cash predictability is low, two conclusions stand out. First, cash needs to be highly accessible. Second, a reserve cash balance for unexpected events becomes more important.

For the day-to-day cash same-day access is critical. This will rule out term deposits or notice accounts. While these may classify as cash from an accounting perspective, that will not help when cash is needed immediately. Only instant access bank deposits (e.g. current accounts) and money market funds (MMFs) can provide same day access to cash.

For the reserve cash portfolio, access also needs to be rapid, but potentially not same day. This opens the door to using some notice accounts or term deposits, and to consideration of non-same day funds. An over-reliance on notice or term accounts can however delay access to cash, which can quickly become an issue in stressed market conditions. Some investors may use “step-out” strategies for their reserve cash portfolios. These can bring the benefit of a higher yield, and potentially diversification, usually with one- or two-days’ settlement. However, these may not classify as cash from an accounting perspective, but as short-term securities.

Conversely, where cash predictability is high, a treasurer can approach cash as almost all “reserve”, and therefore seek to increase diversification and yield, while still, of course, being mindful as to how quickly cash can actually settle into their accounts.

Money market fund characteristics

MMFs are widely used by corporate treasuries because they:

• Usually provide same day access to cash, making them comparable with overnight bank deposits.
• Aim to generate market levels of yield, tracking benchmarks such as €STR (the euro short-term rate). Overnight bank deposits, in contrast, will typically offer (variable) interest rates below market levels due to banks’ own cost of funding and net interest margin policies.
• Provide a diversification benefit by investing in a wide range of issuers – compared with the single counterparty exposure inherent in any banking relationship.
• Are managed to strict regulatory rules and, in some cases, rating agency rules. Where MMFs are rated, they can achieve very high ratings, including AAA, where they invest only in very high credit quality institutions.
• Are typically classified as cash equivalents for accounting purposes

Conclusion & key takeaways

In conclusion, liquidity management in treasury is a critical function that ensures a company can meet its short-term obligations while optimising cash utilisation and enhancing profitability. By aligning liquidity management with broader company objectives, treasurers can support financial stability and strategic growth initiatives. Balancing liquidity needs with investment opportunities requires careful forecasting, scenario analysis, diversification, and maintaining liquidity buffers. With these strategies, treasurers can navigate the challenges of liquidity management and drive sustainable financial performance.

For an overall picture of a investment approach—including treasury and liquidity management alongside our broader fixed income and responsible investment strategies, please visit the Aviva Investors Investment Products and Capabilities page.