How can a well-structured investment policy impact your bottom line?
Plans, policies and strategies: You most likely use these terms on a regular basis when you’re talking about corporate investments.
Four Reasons You Need an Investment Policy Now addressed how an investment policy can help maximize profitability, drive efficiency, and reduce risk. Here, we explore how various investment strategies and planning considerations can affect that critical bottom line – your company’s cash flow.
Consider these 3 key components when developing your investment policy.
GOALS: Determine Your Objectives.
Start by asking yourself what you want your investment policy to accomplish. Work with your company’s financial decision-makers to determine the objectives that make the most sense for your organization. This will pave the way toward the steps you’ll need to take to achieve these objectives.
Poor cash management is the driving force behind many business failures, so begin by identifying factors important to your organization’s cash management. These typically fall into three categories:
- Operating costs
- Financing costs
The specifics of your investment policy will depend heavily on your financing and operating cost calculations.
Once you have an idea of these numbers, the next step is to determine where you are willing to put your investment dollars. Risk/return trade-offs are important to understand, but they are only part of the equation.
According to the Association for Financial Professionals 2015 Liquidity Study, nearly 65 percent of organizations surveyed felt safety was the most important short-term cash investment objective in today’s economic climate.DIS-471-DIS This means financiers and companies will have to spend more time thinking about risk and diversification in terms of liquidity, especially given the low rate environment. This may directly impact your financing decisions – what it will cost to borrow if your cash flow is not sufficient and how it will affect your return on investments.
Your goals and objectives should explore, by investment option, how much diversification is necessary. Counterparty risk, also known as default risk, is an important consideration when thinking about asset diversification. Investments that allow access to some, if not all, of the invested funds can provide safety. For example, a money market account placed with a low risk counterparty, such as an established financial institution, typically permits as many as six withdrawals a month, more than one a week. Your business can access these funds in the event of an unanticipated cash flow emergency.
At the most basic level, you need to make sure that you can meet your obligations – you’re able to pay your venders, suppliers and employees. An investment policy should break down your short-term liquidity needs, then incorporate a moderate or mid-term buffer, sort of your “rainy day fund,” and your longer-term needs, often reserved for specific long-term projects or investments. All these categories can dictate how little – or how much – your company places in various short-term and long-term instruments.
- Short-term needs are the funds required to run your day-to-day operations
- Mid-term needs include cyclical expenses, such as quarterly taxes or bond payments, or volatility in business volumes
- Long-term considerations might include equipment or facility replacement
Determine what you would feel comfortable with as a buffer to hedge against any unexpected impacts in each of the three areas. In some businesses, that may be a lot more than in others. You want to identify what is in your strategic business plan for the next one- to three-year horizon and make sure you have the right capital set aside and earmarked for those projects.
OVERSIGHT: Decide who is in charge.
Consider who should be responsible for managing your investment strategy. Which members of your managing board or who from senior management should be consulted before changes are made? Who will select the appropriate investment vehicles?
Decide whether your policy managers will be internal or external, such as a financial professional with your bank. You might even consider a combination of both. An internal manager may be more equipped to deal with day-to-day decisions and can draw on input from an external source in more critical situations. Including an external component can provide a more detached perspective and a valuable second opinion.
RISK MANAGEMENT: Assess your risk.
Your company’s appetite for risk and ability to sustain risk will drive how, when and where you invest your money. It may be helpful to create a qualitative mission statement to define your company’s overall risk philosophy. You can quantify percentages and include items like:
- How much of a differential your business can sustain between liquidity needs and investment performance
- What to do if any accounts fall under a specific level of their current ratio
You may decide to implement some type of trigger mechanism to alert leadership when a liquidity event occurs or when an issue arises that necessitates identifying other sources of funding. When certain thresholds aren’t met, different response levels would be triggered, the most serious of which could require bringing the issue to senior management’s attention with a recommendation for a solution. Whichever direction you take, your investment policy should outline the rules and actions you intend to implement when a trigger event occurs.
As you assess your risk tolerance, you might consider outlining certain permitted investments and specifying the instruments your organization feels comfortable investing in based on rating, type and asset allocation.
Learn how we can help guide you through the process.
Your company’s investment policy can be critical to its success, but creating and implementing a policy doesn’t have to be intimidating if you address these three key components. We can work with you to answer the questions you have as you develop your company’s policy.