In periods of economic growth and prosperity, funding for small, medium and large businesses is plentiful. Capital providers are eager to expand their activities. As supply of capital and liquidity increases relative to demand for capital, the terms under which businesses access capital and liquidity loosen. Leverage ratios increase, interest rates decrease, reporting requirements decrease, and covenants and lender protections gradually melt away. These conditions provide business owners the luxury of many options, such as paying down debts, making a long-desired acquisition, paying a dividend or buying out an aging or inactive partner.

However, in periods of economic stress, this process can shift into reverse rather abruptly. Leverage ratios naturally increase as cash flow generation declines and debt levels remain fixed. Capital providers begin tightening terms as they focus on protecting existing loans and investments as opposed to providing new capital. The questions facing owners start to change. What happens if I violate a covenant in my credit facility? What happens to my liquidity if my customers take an extra 30 days to pay their bills? Should I put that capital expenditure plan on hold for now to preserve liquidity? Do I need to put more capital into my business now to weather the storm? Should I extend my payment terms to vendors or ask my landlord for temporary relief?

The answers to these questions are unique for each business, and while there is no specific playbook for managing liquidity in a period of global pandemic, many time-tested principles can help guide business owners through this period of volatility. The Brown Brothers Harriman (BBH) Corporate Advisory & Banking team is actively working with clients to help them think through liquidity management. We advise clients to focus on a three-pronged strategy:

1. First, measure your liquidity early and often.
2. Second, stress test your liquidity through modeling and forecasting different scenarios.
3. Finally, craft a strategy to maintain and enhance it.
   

Measuring Your Liquidity

The most common way to measure liquidity is by looking at the ratio of your current assets to current liabilities, or your current ratio. In general, the higher the ratio, the more liquidity you have. The current ratio measures your ability to convert current assets, including cash and cash equivalents, marketable securities, inventory on-hand and accounts receivable to cash. This is measured against obligations you have coming due in the next 12 months. Other metrics, such as the quick ratio, conduct a similar test but exclude inventory, which – depending on your business – can take longer to convert to cash and may be necessary.

One flaw in these ratios is that in a period of economic stress, cash conversion cycles slow down; quick assets become less quick assets. Receivables take longer to collect, and inventory often takes longer to sell. For clients with highly coveted inventory (the “toilet paper effect”), supply chains can back up.

We advise clients to dissect balance sheet categories and understand how quickly you could convert each asset to cash and at what value. Traditional cash should be easy, and the value should be fairly certain. However, make sure “cash” really means cash. Is the money in an overnight demand deposit at an FDIC-insured bank? A money market fund with daily liquidity? Or could it be a liquid investment with potential to decline in value? The value of marketable securities may have declined; as such, you may prefer not to tap these resources immediately. Setting up a line of credit with your investment advisor can help you avoid liquidating long-term investments at the worst time. Be conservative in valuing current assets; assume late payments on accounts receivable and softening demand/price reductions for inventory. Assume you may need to sell inventory at a discount to raise liquidity.

Private business owners may also factor in their personal balance sheet when measuring liquidity. Maintaining dry powder outside of the business can be a valuable tool to improve liquidity quickly. For businesses with a single owner, the process of adding capital to your business is fairly straightforward, but for partnerships or family businesses with multiple shareholders, the process can be more complicated. In such situations, shareholder loans to the business may be the optimal structure.

Liquidity Forecasting

The best-managed businesses will frequently simulate liquidity stress scenarios. This financial modeling exercise involves projecting a slowdown in cash receipts while demands on cash resources increase; for example, what happens if your sales slow 20% over the next three months, receivables take 30 days longer than usual to collect, and you have to change vendor payment terms to cash against documents or prepayment to secure scarce raw materials? Your BBH relationship manager can help you model this risk to better prepare you for the wide range of potential scenarios. In an extreme scenario, what happens if revenue slows to a halt? How much cash do you have to survive four weeks of virtually no revenue? Eight weeks? Suffice it to say that in periods of stress, businesses will often put liquidity over profits in the short term. The ability to perform with your suppliers and customers is a function of liquidity in the short term and will likely provide commercial opportunities that position you for growth when the stress subsides.

Managing Debt and Liquidity

What happens to credit facilities when revenue declines, accounts receivable collections slow and inventory accumulates? Liquidity structures governed by asset-based or borrowing base naturally constrict available liquidity. Companies borrowing on cash multiples (for example, debt/EBITDA) may edge closer to breaching covenants due to declining EBITDA. If you expect to violate covenants or have issues with eligible collateral, you should proactively communicate with your lender. Lenders are more likely to respond positively if they know of problems before they occur.

For businesses severely affected by the COVID-19 pandemic, accessing Small Business Administration loans may be critical to survival. Get to the front of the line by submitting your application early, and see BBH’s coverage of the CARES Act here.

What’s more, the crisis may also affect lenders’ liquidity profiles, creating a knock-on effect to their borrowers. Direct lending funds may have rising defaults in their portfolio, restricting access to the bank liquidity they use to fund loans. Traditional banks may be more focused on managing credit issues than lending new money. Funding costs could be rising, especially for lenders with no natural deposit base. Understanding how your lender funds itself is critical. Does it have a natural deposit in the U.S.? Or must it access funding in the wholesale market? Does the bank have any sector concentrations in its loan portfolio that could expose it more to credit losses in this environment?

A Strategic Approach – Liquidity over Profits

Liquidity is the lifeblood of business. This truism becomes even more apparent in periods of economic duress. Understanding, measuring and forecasting your liquidity position is crucial to enduring periods of economic contraction and ensuring your business continues to thrive as economic conditions improve. Business owners have many helpful tools. Consider liquidating inventory to raise liquidity, even at the expense of short-term profitability. Develop a communication plan with all of your stakeholders; overcommunicate with your customers, and be ready for payment delays. Negotiate extended payment terms with your vendors if necessary. In order to enhance your liquidity position, you must have these challenging conversations with all of your stakeholders: employees, customers, vendors, landlords and even lenders. How you manage each stakeholder will directly impact your liquidity position. For the businesses most affected, buying “insurance” to increase liquidity may be worth the temporary hit to profits. Businesses with strong liquidity positions will weather the storm. Those who manage it best will have the best opportunities to grow again when the sun shines once more.