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Capital Ideas: Strategically Managing Excess Cash

Whether a company thinks low interest rates are great because they make it cheaper to borrow money or awful because they erode the return on savings, the fact is everyone is stuck in the current credit environment and could be for quite a while.

The Federal Reserve has kept the federal funds rate (the rate banks use to lend to one another) near zero since 2008, and it has given no indication that it plans to budge. Many firms are in a position to assess the best way to manage their existing cash and grow their liquid capital. The best way to go about doing this depends on the firm’s goals. Some contractors want to expand into other regions, and others want to acquire a business in their existing footprint. The best thing to do with excess cash is manage it appropriately in light of strategic objectives and for the best risk-adjusted return possible.

The Real Return on Cash

When it comes to managing excess cash, companies can sit on it, use it to buy property or assets, or invest it in CDs, money market funds, bonds or stocks—or some combination of these things. However, in most intermediate and long-term cases, sitting on cash isn’t the smart play.

Cash may feel safe, but it earns nothing in today’s environment. In fact, with inflation at about two percent, it earns less than nothing. Eventually, holding cash in excess of operating needs could put a company at a competitive disadvantage. The same is true for CDs, whose rates have plummeted in the current environment and often fail to appreciate faster than the inflation rate.

This is why many contractors are turning to bond markets. While bonds have risks, specifically when interest rates and inflation rise, they’ve always been a trusted way to preserve capital and produce income, especially during periods of stock market volatility. Regardless of where excess cash is invested, the first step is evaluating the company’s internal capabilities.

Assessing the Firm’s Treasury Function

Contractors often spend a lot of money on marketing and equipment, but not on establishing a dedicated treasury team with the resources to effectively manage the company’s cash on hand. This leaves the CFO or controller to haphazardly buy investments when cash piles up instead of making specific, targeted investments that come due at just the right time to support the overall business strategy. Instead of preserving the company’s value, this unfocused approach could jeopardize its health and put its future at risk.

Making calculated investments is part of strong treasury management: balancing the need for liquidity with the need to grow the company, whether through investing money back into the business or investing it in marketable securities such as stocks or bonds. The key to this process is linking working capital to strategic objectives to ensure liquidity is aligned for moderate growth and is available when needed.

What Does a Plan Look Like?

Barring internal expertise, an advisor can help plan an approach that’s tied to the firm’s goals and then manage its investments. A good advisor will look at three main things:

  • Where the company’s idle cash is, what it holds today, and what its entity structure and taxes look like;
  • The company’s cash flow over the past one or two business cycles (where it has ebbed and flowed and whether it went below certain thresholds), how that cash was structured and whether the firm tapped into credit; and
  • Where the company is going, what its needs are and how it plans to get there.

This framework will help a company and its advisor tie existing liquidity to strategic business objectives. Next, create a customized investment policy statement (IPS). This document, much like a business financial plan, lays out the investment strategies that will be used to meet business objectives. These will vary depending on the needs of the business, but an IPS should cover the following, at a minimum:

  • Purpose and communication. Define intended goals and expected outcomes and create a communication plan.
  • Timeline. Establish short-term, intermediate and long-term investment objectives.
  • Risk assessment. Identify investments based on security type, amount and quality.
  • Accountability. Monitor and report on the investment strategy in light of strategic goals.

Along with picking appropriate investments and timing their maturities to specific needs, the advisor should take into account the firm’s current and future tax planning. For example, whether a company should buy taxable or tax-free bonds could depend on its entity structure, potential tax exposure and the possibility of changing tax rates.

Seasonality is another important consideration for many contractors. As a result, an investment strategy should take into account whether the business requires more cash flow during the winter. If so, investment payments can be structured accordingly.

The Bottom Line

Each construction business has its own goals and financial outlook. The cash management process won’t be the same for every contractor, but it should be based on the same fundamental principles of keeping risk low and having the right amount of cash on hand for short-term, intermediate and long-term needs.

The treasury function is often one of the most overlooked elements of a contractor’s business, and a well-executed one can mean the difference between losing cash to inflation and enjoying healthy returns and liquidity when needed. Contractors must seize every advantage they can to win more work and remain competitive, and smart treasury management can be part of the solution.

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