Liquidity: When the Well Runs Dry

In the years running up to the financial crisis of late 2008, companies had ready access to finance. Banks were eager to lend, and many companies managed their liquidity in those prosperous times with relative ease.

However, as the liquidity dried up in 2009, many companies found themselves unable to obtain new loans or even refinance existing ones. Chief executive officers (CEOs) and chief financial officers (CFOs) also caame under increasing pressure from their company boards, which were demanding greater clarity to the company’s ability to remain viable and liquid.

This tight liquidity market, therefore, compelled many companies to take a fresh look at their liquidity risk management practices in areas such as:

  • Working capital efficiency.
  • Maintaining access to credit markets.
  • The accuracy of key cash flow assumptions.
  • Cash flow forecasting abilities, especially over a one-year time horizon.

What rang out clearer than before was that years of easy credit had either devalued the importance, or impeded the development, of a culture of maximising internal sources of funding and accurate cash flow forecasting processes among companies.

Liquidity Management Defined

Liquidity management is a concept broadly describing a company’s ability to meet financial obligations through managing cash flow, funding activities, and capital management. In itself, it can be challenging as it is affected by revenue and cost-generating activities, capital and dividend plans as well as tax strategies.

Additionally, it is closely linked to broader market, credit and general business risks and, in the recent economic downturn, excessive caution in lending by banks. Given the increased incidents of corporate failures in 2008 and 2009, liquidity management became a frequent agenda item at both board and audit committee meetings.

While each company is unique, queries at these meetings have typically centred around renewed liquidity transparency and governance.

Enough Cash to Fulfil Obligations?

The economic crisis of 2008 and 2009 drove company management and its directors to seek more frequent liquidity updates. These included monthly rolling base case cash forecasts and stress scenarios covering depressed market and operational conditions as well as credit facilities.

Companies with leading practices had typically established formal liquidity thresholds, contingency plans and internal accountabilities. All of these assisted their management and directors to gain visibility and evaluate liquidity risk.

For example:

Cash flow forecast using standardised assumptions

Cash flow forecasting is more than just filling simple spreadsheets or having a system to capture the forecasts of business units. It should instead be a workflow developed over time and embedded into the culture of an organisation. Only then can a company obtain accurate cash flow forecasts to maximise all its available cash.

Forecasting using standardised assumptions works by using the best estimates of cash in- and outflows over a selected duration. It uses common, enterprise-wide assumptions such as revenue and expense forecasting, including short- and long-term interest rates, foreign currency rates, counterparty default rates, product margin, and payment terms.

It can be very challenging to co-ordinate and ensure the accuracy of cash flow forecasting for larger, international and highly decentralised organisations. However, there are clear benefits through improved cash flow aggregation, awareness and financial cost saving.

In the years prior to the 2008 financial crisis, companies enjoyed ample liquidity when banks were eager to lend. Companies therefore had little incentive to develop accurate cash flow forecasting processes. As liquidity dried up in 2009, many companies found themselves unable to obtain new loans or refinance existing ones, making it critical to maximise internal funding. Companies that had not developed a corporate culture embracing accurate cash flow forecasting and processes – even for the shortest durations – were therefore unable to maximise internal cash sources.

Scenario and stress tests

Company treasury functions are increasingly being requested by their management to test and report base case scenarios under various ‘downside’ conditions.

These stress-test results reflect cash flows and credit facilities available under distressed revenue and expense environments, using worst-case, management or regulator-defined scenarios. These tests allow a company’s management and its directors to assess the degree to which core forecasts and assumptions are negatively affected by prescribed events, their impact on an organisation’s ability to satisfy certain obligations, and the organisation’s risk exposure.

Twelve-month rolling cash flow and stress forecasts

Many organisations view liquidity risk on a short-term basis, performing cash flow forecasts of one month, or at most, three-month intervals, largely driven towards supporting working capital and short- to medium-term financing needs.

However, the trend is shifting towards addressing a one-year or longer time horizon, reported on a rolling monthly basis. The benefits achieved through a longer liquidity window include greater transparency of significant cash outflows, and more time to employ various measures to satisfy such obligations.

Some measures to address liquidity include:

Liquidity thresholds

While base case and stress scenarios can increase awareness of liquidity issues, their results may lack the context required to drive desired action.

Some organisations have, therefore, turned to liquidity thresholds and supporting contingency plans. The liquidity threshold typically represents a formal tolerance level (or band) triggering management oversight or remediation. Some examples include maximum credit facilities and ratios relating to downgrade risks and capital structures.

Liquidity contingency plans

Once the liquidity thresholds are established, company management may assign permitted or required actions (liquidity contingency plan) to each tolerance level or band. A liquidity contingency plan typically guides management through various liquidity scenarios. For example, minimum cash and liquidity balances or permitted funding sources and mix. In addition, the contingency plan can assist directors to quickly ascertain critical liquidity risk thresholds and desired outcomes under normal and extraordinary times.

Liquidity governance

A key aspect of any liquidity management programme is prudent oversight and formal policy documentation. Liquidity policies typically address definitions and scope – key reports, timing and distribution guidelines – thresholds, limits, and contingency plans.

In addition, many companies also provide their directors with supporting analysis evidencing liquidity programme completeness, reasonableness and control effectiveness. Some companies are also taking aggressive steps to assess liquidity risk and protect capital through the following short-term actions, including:

  • Drawing against credit lines to test and confirm availability.
  • Taking initiatives to reduce working capital needs.
  • Deferring capital expenses and strategic acquisitions.
  • Restructuring service provider and lease contracts.
  • Asset sales.
  • Government support and often as a final resort, reducing headcount.

In short, there may be no larger risk to any organisation than its ability to accurately forecast cash and maintain suitable liquidity.

Yet, many executives likely agree that liquidity risk management practices, with the exception of one-off measures driven by recent conditions, often lack one or more of the following key components:

  • Sufficient transparency at the executive management and board levels.
  • Formality and rigour in respect of protocols and key organisational assumptions.
  • Sophisticated tools and analytics commensurate with stated exposures.
  • Clear organisation accountability.

As board members and management aggressively work to ensure that their organisations remain competitive, parallel effort should be taken to evaluate and enhance liquidity risk transparency and governance. It is simply an issue company boards cannot afford to ignore.

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