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:
- First, measure your liquidity early and often.
- Second, stress test your liquidity through modeling and forecasting different scenarios.
- 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.