Focus on Liquidity Management: Maximising Growth Opportunities

A recent Roland Berger study among board-level managers and financial controllers at major UK corporations revealed that firms were failing to control costs effectively in the face of these financial woes, and were dragging their feet over urgently-needed restructuring. However it also revealed significant liquidity issues that were being exacerbated by late-paying customers and the ongoing difficult credit conditions.

Nearly all companies (94%) report a rise in late payment, and a similar proportion (95%) expect customer payment behaviour to worsen further in coming months. Additionally, a third of firms have suffered a reduction of credit lines to date, and a similar level are still experiencing difficulty in obtaining new loans. These findings indicate the situation has barely improved since early 2009, when a previous study revealed that banks had withdrawn unused credit lines from 34% of firms.

The level of reduced credit lines and difficulty in obtaining new loans does appear to be less prevalent in the UK than other regions, especially in the US: 78% of US participants have suffered credit line reductions, and 56% are experiencing difficulty in obtaining new loans.

Furthermore, a reduction of trade credit insurance lines for customers in 20% of companies interviewed (26% for suppliers) has resulted in some companies not being able to trade on existing terms and having to raise further working capital funds that can drain already depleted liquidity reserves. We have seen in a number of recent restructuring cases that this can have a major impact on the options and levers available. Nearly half of companies also believed in a high risk of key suppliers going insolvent, Providing credit to suppliers was considered to be the key measure to take to reduce this risk. This significantly impacts the ability to reduce the level of working capital, as companies need to consider the potential impact of not having key suppliers, versus reducing its working capital level.

As a result of the lack of liquidity caused by the recession, the UK’s largest firms will be unable to respond to the economic upturn when it emerges. Companies did not anticipate recovery until well into 2010, but hit by factors such as poor turnover, an ongoing credit shortage, late-paying customers and pressure on interest cover, they will be unable to respond to the upturn for a further six months after it commences.

A January 2010 Roland Berger survey on UK companies’ budgeting challenges in light of the uncertain economic conditions, found that there has been an increased focus in cash and liquidity management (up from 55% of respondents in 2009 to 68% in 2010). Liquidity is still expected to remain a top issue for this year and therefore the focus on ensuring appropriate management procedures are in place will remain for the near future at the very least.

From recent projects and discussions with clients, we have also noticed that most companies have tried really hard to ensure that their current working capital levels are as lean and low as possible. In the short term, during the crisis, this does release much-needed liquidity for companies. However, companies need to be very careful not to put themselves at a disadvantage when the recovery fully materialises.

The issue is that, as recovery takes hold, and in order for companies to take full advantage of the opportunities, there will be a working capital requirement. This requirement could well be magnified if the current working capital levels are at the lowest possible levels. With the current finance markets still not working well, companies might find it difficult to finance the working capital requirements and as a result miss out on the potential recovery opportunities.

Our recent experience has also shown how the crisis has caused even greater difficulty for companies that operate early in the supply chain, especially in the supply base for heavy industry. Where a customer experienced a decrease in revenue, the impact on suppliers was greatly magnified through a de-stocking effect (sometime up to five times greater), as the customers were holding excessive stock levels.

The issue now, for the suppliers that have navigated through the crisis, is that, as their customers markets recover, they will need to restock. Even though this could be a temporary spike in demand, there will be a significant working capital requirement for the supplier to meet the demand. This will be a major issue for the supplier to finance – if their liquidity management is not sufficient then the upswing opportunities could easily be taken by competitors that have better managed their liquidity.

Best Ways for Corporates to Manage Liquidity

No matter the size of an organisation, cash is obviously a key requirement to ensure its success and continuation of business. As a result, liquidity management is an essential part of the day-to-day actions of management.

The level of liquidity management requirement varies greatly, not only due to the size of the organisation but also significantly from the type of transactions taking place (i.e. cash-based transactions, long-term contracts, manufacturing products versus providing services, for example). There is, however, one basic principle that should always be followed to ensure liquidity can be successfully managed. This is to provide visibility as to the cash position of the organisation at any given time in the past, present or future. Any organisation that can provide reliable information can at least manage liquidity effectively – whether they then do this is another matter.

To ensure the best possible liquidity management, companies need to ensure they cover all of the following points in liquidity monitoring:

  • Forecasting – keeping short-term (receipts and payment method), medium-term and long-term forecasts regularly updated is essential in maintaining the visibility required to make the right decisions.
  • Cash controlling – cash policies, signature structure, tax efficiency and bad debt monitoring will ensure that any cash leakage is kept to a minimum.
  • Reconciliations – cash/bank reconciliation, accounts receivable (A/R) and accounts payable (A/P) reconcilation will ensure the robustness of the information available. This includes transparency over cash inflows and outflows across all bank accounts and cash reserves as well as the reconciliation with balance sheet movements.
  • Banking – creating a strong relationship with the bank and sufficient management of bank accounts to meet needs (not over-complex), cash pooling, and cross-border management will ensure that all available cash is readily accessible. This includes developing an adequate loan structure that meets the short- and long-term financing requirement of the company.

This should allow management to have sufficient information to make the right liquidity decisions, realise if there is a liquidity issue that needs addressing and understand the potential liquidity requirements for the future.

Controls can be put in place to prevent risk exposure. Most companies following best practice in liquidity monitoring, as stated earlier, should be able to understand what their liquidity position is at any given time. However, even if all the monitoring procedures are in place, this does not mean that the right liquidity decisions will always be made. There are a few further controls that should always be in place to ensure that management can make the right decisions.

The essential liquidity controls for any company include:

  • Risk management – cash policies and signature structure, foreign exchange (FX), hedging, and asset management will ensure that unforeseen events will have a limited impact on the company’s liquidity position and that assets are not stolen.
  • Working capital – balance management, invoicing and tight and transparent payment controls ensure that amounts due are received in time and supplier payments are optimised to allow sufficient growth but without tying up unnecessary amounts of liquidity. Bad debt management is also crucial, to minimise the leakage in converting sales into cash.

Combining these control process with appropriately-set levels of financial key performance indicators should ensure that a company does not overexpose itself, as management should have all the procedures to make the right decisions. These KPIs can be very simple, such interest to EBITDA ratios, or more complex, such as a level of hedged transactions in foreign currencies to limit exposure to currency fluctuations.

However this does not mean that liquidity will not be an issue at some point in a company’s lifespan, as all the procedures in place can’t allow for external developments outside of management’s control. From our extensive experience of restructuring situations, we have found that most of the organisations that have to go through major restructurings have insufficient liquidity management procedures in place for their size and type of business.

In simple terms, there are many techniques that are very useful in preventing liquidity risk exposure. However, the first step should be to ensure that the more basic monitoring and controls are securely embedded in the day-to-day management procedures of the business. Following this, a company that requires more complex systems should individually tailor their systems to their particular requirements as there is no ‘one size fits all’.

Our restructuring experience shows that too many organisations underestimate the role that liquidity management can play in the day-to-day running of an organisation and how it can provide early warning signals of deeper issues. Conversely when liquidity issues do arise, many companies will focus on refinancing/securing financing for the most urgent needs without addressing the root causes, which might well be operational or strategic. This financial restructuring to ease the liquidity issue will only, therefore, be a short-term fix and the ‘bleeding’ will continue until the more operational or strategic issues are tackled.

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