Cash Flow Management: Gauging Risk VS Reward with Corporate Capital Investments During Inflationary Times

Posted October 19, 2022

Startups, midsize and large corporations are all feeling the burn of inflation in their cash reserves. Inflation continues to hurt the spending value of the U.S. dollar domestically.

Now Adam Zaki a contributor for CFO.com recently published an article that states that chief financial officers and treasurers at large companies that have substantial cash on their balance sheets have started to give more attention when analyzing their company’s cash reserves.

Mr. Zaki found from interviewing a number of CFOs that many organizations (both public and private) are sitting on cash to create a buffer against an incoming recession or because they are waiting for the right opportunity to deploy or allocate those reserves. Financial executive managers in both public and private sectors have started to find more ways to safeguard the long-term value of those capital reserves but also must choose wisely when making investments. Now a small business is not going to have as much cash on its balance sheets as a large corporation but managing cash flow and accessing risk vs reward is prudent for any sized business.

Understanding Risk VS Reward with Capital Allocation Investments

The CFO article author spoke to Dan Tolomay, CIO of Trust Company of the South, and asked about how executives looking to protect their company’s capital, should go about it by thoroughly analyzing risk vs reward with investments in capital expenditures. Mr. Tolomay stated that “risk and return are directly related.” He went on to further explain“when you bear more risk, you should expect a higher return. We think of risk as a spectrum with purchasing power risk at one end and market risk at the other. Being too conservative with cash can mean losing purchasing power to inflation. Getting too aggressive can lead to damaging losses.”

The article also mentions that CFOs must be able to navigate and tolerate risk to a certain extent. It’s important to have some patience in seeing the results of capital investments while also being able to strategize with both short- and long-term goals in mind. Just as important is not getting caught up in day-to-day market fluctuations.

Risk Tolerance has Two Dimensions

There are 2 aspects to “risk tolerance”, 1 is the ability to bear risk, and 2 is the willingness to bear risk. Mr. Tomlay stated that “the goal is to align them so that enough risk is taken to meet the goals, but that not too much risk is introduced where the plan could be abandoned under duress.”

Some Corporations Are Using Money Market funds To Preserve Cash Reserves Against Inflation

According to another CFO.com article, Money market funds once seemed to be the perfect short-term investing vehicle to invest excess corporate cash because they offered stability of principal, diversification, and daily liquidity. Over the years, though, corporate treasurers have allocated a smaller portion of excess cash to prime funds. On average, companies had about 5% of their short-term cash in prime or diversified money market funds in 2021, according to the AFP’s annual liquidity survey. That is compared with 52% in bank deposits and 17% in government or Treasury money market funds. Mr. Tomolay mentioned that “money market yields track the Fed Funds rate, so there’s been an increase in return there,” he said. “The yield on the fund that we use has risen from 0.03% to 2.69% year to date.”

For Chief financial officers and corporate treasurers that searching for stable value, frequent liquidity, and floating yields, these types of funds can be useful financial instruments. “Money market funds are great for cash needs where the timing is unknown. They provide a stable value, daily liquidity, and a floating yield that should rise as the Fed continues to hike,” said Mr. Tomolay.

Many public and private corporations have been getting more conservative with managing capital/cash on the balance sheet allocations during this uncertain inflationary period over the last 9 months. With bonds becoming a more attractive option Mt Tolomay stated that “assets that had flowed from cash and bonds to riskier assets in search of a meaningful return may now reverse course.”

Relatively safe and liquid money market funds, Treasury bills, and other credit instruments have attractive rates again because of the Federal Reserve’s interest rate hikes. Inflation, of course, has also made seeking some yield prudent — cash idle on balance sheets becomes less valuable by the day.

Growing The Investment Income

Corporations with large cash reserves and big organizations such as public municipalities that were the recipients of a substantial influx of federal dollars from the pandemic have been finding ways to park their dollars in investments that not only protect them from inflation but produce dividends. Those dividends, unlike the investment principal, are not constrained by federal guidelines on how the money can be spent.

For example, Kevin Bueso, CFO of McHenry County, Illinois, told CFO.com, that in 2021 and 2022, his county saw a 60 million dollar infusion of cash of federal funding during the pandemic, and they made the decision to find a better use of that capital than just letting it sit a regular bank acct and depreciate. One thing they did was to invest some of those funds into mortgage-backed securities (MBS), and despite the bad wrap and role they played in the 2008 financial crisis, Mr. Buesco believes that mortgage-backed securities are a good example of an investment that can preserve the long-term value of large amounts of capital. He explained that despite the label MBS’s have, “they’re still out there, and they’re safe, and they are yielding a lot more than a money market savings account or a CD [certificate of deposit].”

How to Balance Capital investment Risks?

Mr Bueso discussed that when his team was evaluating investing risk, they used a strategy where he and his team work within the parameters of both state and federal regulations while also trying to allocate toward investments on behalf of the county and within areas of the community that need funding. As inflation has been eating into state budgets, the half a million dollars a year in dividends the county is getting off of investments is helping balance out some of those costs.

He said his team meets to discuss capital allocation investments and ask the question how can we do this in a responsible manner, where, yes, we’re helping our community, but at the same time we’re realizing some serious investment income? He stated that they experiencing a greater return on their investment, and are funding a lot of projects with this investment income that is not tied to anything.

Bueso said his county’s financial situation is taken into account when he evaluates some risks. As McHenry County has a history of strong internal economic policies and pledge agreements on investing, he believes the investment decisions are helping the county long term.

Conclusion

There are tremendous advantages to having and building cash on the balance sheet.

The company is better able to take advantage of changes in the market.
The company can be agile in making acquisitions.
The company can pay down debt and be prepared to weather a future storm. There is nothing like having a strong balance sheet.

And no matter if you are a large company, a high-growth startup or a small business it’s always a good idea to find ways to manage and improve cash flow, whether that is managing days cash on hand, working capital optimization or improving cash conversions. In an ideal business environment, a company would not need to operate solely on its cash reserves, but when a downturn or disaster hits hardly comes at a time when it is predicted.

If you are a business in Southern California contact Huckabee CPA for a free consultation about building out a cash flow analysis for your company.