Four Factors To Consider :

1. Risk
2. Liquidity
3. Maturity and
4. Return.

1. Risk Vs Return

• There is a direct correlation between risk and return: the higher the level of risk taken, the greater the return of the investment.

• How much to risk to take will depend on the appetite of the risk-taking ability of the company.

• For a high risk taker, investing in high risk investments can lead to big profit but can also lead to big permanent losses, which in turn can lead to the company collapsing.

Naturally, the most high-risk type of investment is an ordinary share traded on the stock exchange.

Shares are subject to huge fluctuations in value thus making them such a high risk.

Risk in Shares:

Basically the risk associated with shares can be divided into its two components:

• systematic risk and
• unsystematic risk.

Systematic risk is the variability of returns caused by factors affecting the whole market. It can never be eradicated, so if an investor wants to avoid risk altogether, he must altogether avoid the stock exchange. Unexpected events like the 11 September 2001 can turn the stock market into chaos. Share prices plummeted overnight and recovery was slow.

Unsystematic risk is the variability of returns caused by factors just affecting a specific market sector or group of companies. This element of risk can be eradicated by holding a well-diversified portfolio of investments.

2. Liquidity Vs Return

• The general basic principle is the more highly liquid an investment is, the less return you will get.
• Hence like the link between risk and return, there is also a link between liquidity and return.

• An investment that is highly liquid, such as a sight deposit, will generally result in a lower return on the investment. On the other hand, an investment with a low level of liquidity will generally provide a higher return.

• A company needs to review its cash needs preparing projected cash forecast statement. It needs to estimate the duration of this surplus

• If funds are not then available to cover the cash deficit, the company will find itself in cashflow difficulties. At the least, this will be costly, with the cost of emergency finance no doubt outstripping the returns made from the cash surplus.

It’s important to consider an investment’s liquidity before investing the cash. If the amount and duration of the cash surplus are subject to change, then only highly liquid investments should be considered.

If, on the other hand, the amount of the cash surplus and the duration of it are fairly certain, then less liquid investments should be considered, as these will usually offer a higher level of return.

3. Maturity Vs Return

• Maturity means the length or duration of investments.
• A company’s investments should mature so that the surplus cash is available when the business needs it. This can be assessed by preparing a detailed monthly cashflow budget to cover at least a six-month period into the future. This should be revised on a monthly basis once actual cash inflows and outflows are known for each month.

• By now, you notice that there is a link between risk and return,liquidity and return and there is also a link between maturity and return.

• A longer maturity will generally provide you with a higher return. On the other hand, an investment with a shorter maturity or with no maturity at all will result in a lower return.

4.Return

• Although the whole purpose of investing cash is to receive a return, the rate of return is really the last factor to consider when investing cash surpluses. This is because it is largely dictated by the three aforementioned factors - risk, liquidity and maturity.

• The crucial element is that only after a company has assessed risk, liquidity and maturity, is it then in a position to consider the investment options available to it.