Corporate liquidity is here to stay--for now.

In 2005, U.S. corporate liquidity reached an all-time high of $5 trillion. This $5 trillion represents all bank deposits (interest and non-interest bearing) and short-term investments with maturities of less than three years held by corporations and public sector organizations. The big question for 2006 and beyond is whether this level of liquidity is sustainable. Will companies continue to hold large amounts of cash and short-term investments, or will liquidity levels drop as companies put these funds to different uses?

In 2005, Microsoft Corp. used its $50 billion liquidity portfolio to make dividend payments to investors. Will other companies follow suit by deciding to reduce liquidity levels to reward investors, make capital investments or pay down debt?

In a recent survey of over 600 companies conducted by Treasury Strategies Inc., 70 percent of participants indicated that they expect liquidity levels to either increase or stay the same in 2006. With liquidity portfolios remaining at such high levels, are companies prepared to maximize their return on short-term cash?

This year, companies will likely refocus their efforts on managing their liquidity portfolios. The composition of corporate liquidity shifted to investment instruments offering the best returns; however, companies demonstrated gaps in investment policy management, benchmarking portfolio performance and forecasting future cash needs.

Corporate and government notes and bonds accounted for 29 percent of all liquidity in 2005, the largest single piece of liquidity for the year. This shift toward bonds and notes was likely driven by the returns offered and the subsequent popularity of auction-rate securities. Conversely, companies moved liquidity away from both money market and longer-term funds. Fund products fell to 24 percent of overall liquidity in 2005 from 45 percent in 2004; the drop was largely driven by the upward movement of interest rates (returns of funds tend to lag current market rates).

Companies also increased their investments in commercial paper, which saw somewhat of a comeback in 2005 after bottoming out a few years earlier. All in all, companies did move liquidity to maximize returns in terms of the instruments comprising their portfolios. However, they demonstrated other areas for improvement in the processes involved in managing these portfolios.

In 2005, 29 percent of 600 companies reported not having a documented investment policy, as reported in Treasury Strategies' 2005 U.S. Corporate Liquidity Research. Of those companies that do have investment policies, only half were monitoring policy compliance in a timely manner--either daily or with every investment made. The other half of companies effectively rendered their investment policy useless because they checked their investments versus policy well after the investment had been made. Nearly 25 percent of companies monitor policy compliance only on an annual or less than annual basis! (See an article on updating investment policies on page 59.)

That could be risky. For example, if an investment is deemed "non-compliant," a company may be required to redeem an investment at a loss. Another risk--from an investment-management perspective--is not updating investment policies in a timely manner. Twenty-five percent of companies wait to update their investment policy every four to five years or less often.

A good example of the importance of a current investment policy occurred in 2005 when auction-rate securities were re-classified from cash and cash equivalents to short-term investments. If policies are not kept current, portfolios invested in auction-rate securities would have been out of compliance, possibly also creating broader accounting issues.

Companies may be missing out on maximizing returns on their liquidity portfolios by not following rigorous benchmarking practices. Nearly 40 percent of companies reported not benchmarking these returns. Of those that do benchmark, 75 percent do so internally, with varying degrees of rigor. Those who hire external providers to benchmark were rewarded: they reported returns of 50 basis points higher on the portions of their liquidity invested over 90 days than those that benchmark internally (or not at all). While higher returns cannot be completely attributable to an external provider, it demonstrates that vigorous attention to performance pays off.

Another challenging area is cash forecasting. While over 70 percent of companies forecast, only half use their forecast to make investment maturity decisions for their liquidity portfolios. Companies using their forecast to make investment decisions reported average returns 30 basis points higher on the portion of their portfolios invested past 90 days than those that did not. Companies continue to struggle with the accuracy of their forecasts, driven by the continued need for more information in a more timely fashion from both financial providers and internal departments.

As liquidity levels remain high in 2006, companies have an opportunity to really tighten up the management practices associated with their liquidity portfolios. Improved practices will yield better returns and help minimize risks.

Chrystal Pozin ([e-mail]) is a Principal with Treasury Strategies Inc. in Chicago.