Managing cash surpluses - Short-term investment vehicles and...

Learning Outcomes

After reading this article, you will be able to identify suitable investment vehicles for short-term cash surpluses, describe how each works, and understand the key criteria for selecting among them. You will distinguish between safety, liquidity, and return considerations, and apply this knowledge to recommend and justify investment choices in common ACCA FFM exam scenarios.

ACCA Foundations in Financial Management (FFM) Syllabus

For ACCA Foundations in Financial Management (FFM), you are required to understand how organizations manage surplus cash and the factors affecting their investment choices. In particular, you should focus on:

• The reasons for surplus cash and the importance of cash management
• Key features of common short-term investment vehicles
• The main criteria for selecting short-term investments (liquidity, safety, return)
• How to apply these criteria when assessing investment options
• Examining the risks associated with each investment type

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 provides the highest level of capital security for investing temporary cash surpluses?
   1. Company shares
   2. Negotiable certificates of deposit
   3. Property funds
   4. Venture capital investments

2. Name two criteria that should be prioritized when choosing a short-term investment for surplus cash.

3. True or false? Money market deposits can be accessed at any time without warning or penalty.

4. Explain briefly why an organization may prefer a lower return investment for its short-term surplus cash rather than seeking the highest possible profit.

Introduction

Efficient cash management ensures an organization is able to meet its payment obligations while making the best use of excess funds. Sometimes, cash inflows temporarily exceed outflows, resulting in surplus balances that should not be left idle. Investing these surpluses in suitable short-term vehicles allows businesses to earn additional income, while still keeping money accessible for operational needs.

Investing cash surpluses requires careful balancing between risk, return, and the availability of funds. Choices must be made based on the organization's liquidity requirements, acceptable risk level, and potential returns—decisions regularly examined in the ACCA FFM exam.

Key Term: cash surplus
The excess of cash receipts over cash payments within a specific period, resulting in idle funds available for temporary investment.

SHORT-TERM INVESTMENT VEHICLES

When organizations have excess cash for a matter of days, weeks, or a few months, they need to invest these funds in instruments that are both safe and liquid. Below are the most commonly used short-term investment vehicles.

Bank Deposits

A simple and widely used option, bank deposits provide safety and ease of access. The main types are:

• Demand deposits: Funds can be withdrawn immediately without notice.
• Time deposits: Require a fixed term (e.g., one or three months); early withdrawal may incur penalties.

Interest rates generally increase with the length of commitment, but the organization loses some flexibility by tying up funds for longer periods.

Key Term: liquidity
The ease and speed with which an asset can be converted into cash without significant loss of value.

Treasury Bills (T-Bills)

Issued by governments, T-bills are short-term (typically three to twelve months) debt instruments. They are highly secure and highly liquid, often traded in money markets before maturity if the investor needs to access cash.

Key Term: Treasury bill
A short-term government security sold at a discount, with repayment of face value at maturity (typically within a year).

Certificates of Deposit (CDs)

Banks issue certificates of deposit as proof that a specific sum is deposited for a set period at a fixed rate. CDs can be held until the maturity date, or sometimes sold on secondary markets if negotiated as such.

Key Term: certificate of deposit (CD)
A short-term, interest-bearing deposit issued by a financial institution, specifying maturity date and fixed interest.

Commercial Paper

Large, reputable companies issue commercial paper to raise short-term funds. It typically matures within one to three months. While yields can be higher than government securities, commercial paper involves greater risk.

Key Term: commercial paper
An unsecured, short-term debt instrument issued by corporations to finance short-term liabilities.

Money Market Funds

Money market funds pool resources from multiple investors and invest in a range of short-term, high-quality instruments. They offer instant liquidity, diversification, and competitive yields.

Other Vehicles

Short-term government bonds (with very short maturities), repurchase agreements, and overnight investments may also be available, depending on the market and the investor’s requirements.

CRITERIA FOR SELECTING SHORT-TERM INVESTMENTS

Several critical criteria must be weighed when selecting the most appropriate vehicle for investing surplus cash.

Security (Safety)

Preserving the original capital is a key priority. Organizations usually avoid instruments with significant risk of loss. Government-issued T-bills and insured bank deposits are examples of high-safety investments.

Liquidity

The funds may be required on very short notice—for example, to pay suppliers or unexpected bills. Highly liquid vehicles allow investors to access cash instantly or after very short delays.

Yield (Return)

While safety and liquidity take precedence, organizations seek to maximize income by comparing interest or yield rates among available options. However, chasing higher returns may mean accepting greater investment risk or reduced access to funds.

Maturity (Timeframe)

The expected timing of cash needs determines the maximum investment period. Surpluses required in a week should not be tied up for three months.

Diversification

Spreading cash over more than one vehicle or institution can reduce risk if one provider fails or markets become unstable.

Key Term: diversification
The strategy of spreading investments across multiple instruments or issuers to reduce risk of loss.

Cost and Administration

Transaction fees, early withdrawal penalties, and administrative workload can influence the choice between alternatives.

Worked Example 1.1

A business expects to need $100,000 in cash for supplier payments in ten days. Until then, it wishes to earn a return on these funds. What investment might be suitable?

Answer:
Given the short time frame and the requirement for immediate access, a high-interest demand deposit (call account) or a money market fund would be appropriate. Both options provide daily liquidity and minimal risk, though the return will be lower than in less liquid options.

Worked Example 1.2

Company Z has a recurring monthly surplus of $250,000, available for 30 days before payroll. It wants to earn higher interest but must ensure funds are accessible for salaries without delay or penalty.

Answer:
A one-month time deposit may offer better interest than a demand account, but funds will be unavailable until maturity. Alternatively, short-dated Treasury bills or a money market fund would balance liquidity and return.

Exam Warning

Exam questions may ask you to recommend a vehicle for surplus cash given a scenario. Always prioritize security and liquidity ahead of return, unless the scenario specifically instructs otherwise.

RISKS ASSOCIATED WITH SHORT-TERM INVESTMENTS

While short-term instruments are typically lower risk than long-term investments, there are still risks, including:

• Counterparty risk: The possibility that the bank or issuer defaults
• Interest rate risk: Fixed-rate returns may lag market rates if rates rise
• Inflation risk: Earnings may be eroded by inflation

Most organizations avoid higher-risk vehicles such as equities, property funds, or corporate bonds for temporary cash surpluses.

Summary

Cash surpluses present an opportunity for additional income but must be managed with caution. The organization should select investment vehicles offering high safety and liquidity, while maximizing the return within those constraints. Exam success requires applying criteria to specific scenarios—not just knowing definitions.

Key Point Checklist

This article has covered the following key knowledge points:

• Distinguish between the main types of short-term investment vehicles for cash surpluses
• Understand and define the criteria for selecting short-term investments
• Apply the key selection criteria (security, liquidity, yield, maturity, diversification) in practice
• Identify risks and prioritize safety and access over maximized return
• Recognize scenarios where less liquid or riskier investments are inappropriate

Key Terms and Concepts

• cash surplus
• liquidity
• Treasury bill
• certificate of deposit (CD)
• commercial paper
• diversification