How liquid is your business? Liquidity is the only real test of your ability to pay bills, retain staff, provide goods and services and ultimately keep the business together. Balance sheet figures such as revenue and profit are merely theoretical – can you pay your way or will you be left wishing you had deeper pockets? Paul Godfrey investigates what it takes to be liquid and why it matters so much.
Quite simply, liquidity is the ability of a company to meet its short term obligations. It’s a very ‘real world’ measure of the business’ viability and defines the company’s potential to convert its assets into cash. The phrase ‘short term obligations’, generally signifies obligations which mature within one accounting year, but it also reflects the duration of one complete operating cycle: buying, manufacturing, selling, and collecting.
Anybusiness that cannot pay its creditors on time and cannothonour its obligations to the suppliers of credit, services, and goods is technically bankrupt. The lack of liquidity leads to an inability to meet the short term liabilities, thereby affecting the company’s operations, reputation and very survival. There is also a knock-on effect too, whereby lack of liquidity leads to a worrying downward spiral. For example, lack of cash or liquid assets may force a company to miss the incentives given by the suppliers of credit, services, and goods – which of course results in higher cost of goods, compounding the raft of financial problems and eroding profitability.
Liquidity is defined by your needs
Whileit is always important for a company to maintain a certain degree of liquidity, there is no standard norm that you have to follow, or a template that sets the right standards. This depends purely on the nature of the business, the size of operations, the business’ location, and so on. The liquidity levels required by a supermarket chain like Carrefour or Sainsbury are very different from those needed by a real estate agency, for example.
The importance of protecting the appropriate level of liquidity means that every stakeholder has a major interest in the liquidity position of thecompany. For example –
- Suppliers of goods will check the liquidity of the company before selling goods on credit.
- Employees need to know whether the company can meet its employees’ obligations regarding salary, pension, etc.
- Shareholders are interested in understanding the liquidity due to its huge impact on profitability. (Bear in mind that from an accountants’ point of view, shareholders may not like exceptionally high liquidity as profitability and liquidity are inversely related).
Managing your business’ liquidity position
Liquidity is best understood by comparing Current Assets against Current Liabilities. A company can protect its liquidity position by financing its investments by a combination of current and long term sources. Some of the key strategies for enhancing the liquidity position include –
- Financing the current assets by current sources
- Financing the current assets by long term sources
- Financing non-current assets by short term sources
- Financing non-current assets by long term sources
It is also imperative to accelerate the rate at which funds are coming into the business. For example, it will pay wherever possible to have an efficient collection system for receivables – the fundamental priority here is to shorten your receivables cycles while lengthening your own credit terms with key providers. In other words, get the money in before it goes out!
Facilities such as factoring, invoice discounting and Trade Credit Insurance can all help hedge against erosion in the business’ cashflow position. Remember, though, that these services do not come free of charge. You might be slowly eroding profitability by bringing them on board, and at the most extreme level, you could be diminishing control of yourown decision-making when it comes to selecting core customers and markets, as the insurance providers will often cover only those invoices sent to ‘approved’ businesses.
Liquidity and borrowing – a two-edged sword
Amongst lenders in the GCC, about 45 per cent of all loans are given on the basis of improving a business’ working capital. In many other regions, this would be seen as ‘circular’ borrowing that in practice digs an even deeper financial hole for the business to climb out of.
While borrowing can be a valuable way of boosting cashflow and liquidity, it comes at a price – and ironically, this can also serve to undermine liquidity in the medium term. The cash that now infuses the business may be lent at rates as high as 19 per cent (in the case of secondary or tertiary finance from a high street bank). This means that if your business is working to an overall margin of around 25 per cent – very typical for an SME in the service sector, for example – you could now be forced to work with a 6 per cent margin for the next five years. This may not be an issue while the funds from the loan are still ample and buoyant – but for how long will that be the case? This is why many lenders choose not to lend against working capital objectives, but will only do so against strategic expansion initiatives. Here, the prospect of potential income grows exponentially, meaning that the cost of the loan will be redeemed rapidly and not be severely felt. Whereas in terms of lending for working capital, the overall ‘pot’ only remains the same.
The wise SME will typically tend to retain strong liquidity outside of the need to borrow, but will then borrow in order to explore new markets, make acquisitions or acquire new equipment which can then be refinanced as needs arise (and note that asset refinancing can be an excellent and cost-effective way to boost liquidity).
In these ways, liquidity needs to be seen as the basic starting point for strategic decision-making within the SME, and the preservation of strong liquidity needs to be the determining factor in both day-today operations and future planning. Here’s a useful exercise: what impact did your company’s actions and activities today have on the business’ liquidity and its ability to its way?