The level of liquidity held varies hugely, even between companies in similar industries and similar market positions. Furthermore, few take account of the fact that, due to isolated multinational account structures, much of their ‘safety net’ of cash holdings may be inaccessible when needed.
Banks recommend that organisations should make evaluating liquidity risk part of their treasury policies, alongside other more commonly-evaluated risks such as foreign exchange (FX) exposure. All such risks should be evaluated at least once a year, and put in the context of major strategic events that may be coming up, for example mergers and acquisitions (M&As).
How does Treasury Evaluate the Company’s Liquidity Reserves?
For more than six years, Nordea has employed a proven methodology for evaluating a company’s liquidity requirements. It requires little more than publicly-available metrics from annual and quarterly reports, and treasury’s own understanding of the business’s position.
A company’s liquidity needs are affected by many factors, internal and external, some of which will be outside treasury’s control, and some of which will be extremely subjective and difficult to forecast. Liquidity is not an exact science.
Figure 1: Potential Factors Affecting a Company’s Liquidity Reserve Requirements
Nonetheless, treasury should evaluate each of these factors in turn, looking at potential strains on the company’s liquidity whether caused by a prolonged recession, sudden capital expenditure (capex) requirement caused by a strategic initiative, or deterioration of the working capital position.
Using Scenarios to Model Needed Liquidity
Indeed, one of the clearest ways of measuring the need for the right liquidity buffer is to look into historical working capital fluctuations and the company’s cost structure. Treasury can build a scenario by using the worst-case working capital figures from the past five years of data, and modelling them along with a significant dip in revenue and margins. The buffer will typically need to cover the company’s fixed costs, interest expense, and capex for up to three months, as well as funding inventory, due payables and outstanding receivables.
Treasury should also evaluate the buffer that it currently has available, and how it is structured. Is it made up of undrawn, committed credit facilities, or of cash holdings? If cash, how accessible is it? Cash that is inaccessible should not count as part of the reserve. This is a good time to start thinking about liquidity centralisation through a cash pooling solution, if this has not already been done.
Lastly, treasury should compare the company’s position against that of its peers, assuming that it is possible to get hold of the data. The size of other companies’ reserves will probably vary significantly, and the treasury team cannot necessarily use them as a good example to follow – but it is useful data nonetheless.
To take an example; the table in Figure 2 below shows a company hit by a sudden 20% drop in revenue and 15 percentage point drop in margin, along with increasing receivables, stockpiling inventories, and ongoing costs of business. To absorb these costs, its needed liquidity reserve more than doubles in one year, to 15% of revenue. Some of that is covered by cash and equivalents, but much of its cash is restricted, meaning it needs far greater access to undrawn credit facilities in order to maintain financial flexibility until the market environment recovers.
Figure 2: A Worked Example of how Worst-case Scenario Planning can help Estimate Needed Liquidity Reserves
This scenario starts with a few basic numbers that are easy to establish, and results in a bottom-line figure for credit needed: in this case, €118m.
While setting the right level of liquidity reserve is a critical part of financial risk management, it is no substitute for actively managing liquidity: accurately forecasting cash flow, freeing up restricted cash, and using techniques such as sweeping and cash pooling to improve visibility and control over available funds. And treasury has a role in determining other figures in our scenario, too: by setting and enforcing payables and receivables policies and helping the business maintain appropriate inventory levels (which was discussed in more detail in this article on working capital management). Liquidity reserves should form just part of a treasury’s holistic risk management approach.
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