Re-establish your lost liquidity

The liquidity of a company, although is influenced by the general market conditions, can effectively be managed by factors inside the company. The challenge for every enterprise should be the design and implementation of policies that will wake up the frozen funds of the firm and will provide a real opportunity to regain its lost liquidity.

For a long period of time, that markets prospered and the access to capital and liquidity was easy, companies gave little attention on how to manage their internal sources of financing, since they were focused on growth and profitability. In particular the profitability of listed companies led the stock prices and gave a significant bonus to the executives.

However, the circumstances in the economy changed and the liquidity of the market was significantly reduced. As you know, market liquidity depends on the amount of money circulating in the market and its velocity (how many times change hands). These two parameters that affect liquidity, declined significantly over the last years and in combination with the reduction in funding from the banking system the problem grew.

As a result of this situation many companies face liquidity problem which can lead to insolvency and ultimately bankruptcy. Even robust companies that did not have any liquidity problem in the past, now see their bank account balances to reduce significantly. Their bad debts rise, and their suppliers reduce the credit they offer.

Cash flow and working capital management takes the leading role in business, but this does not consists an innovation or a new method of management. The balance of profit vs cash has to find a new equilibrium.

Enterprises must apply a different model of operation in order to activate the internal sources of financing and awake the funds that are sleeping in various fields of business (non-productive assets, inventories, receivables, etc.).

Making a simple decision to change credit policy and reduce the credit offered to customers is not sufficient to improve the liquidity of the company. To the contrary, it can lead to a decline of sales, shrinking of profitability with an equivalent impact on liquidity.

What companies must do is to understand in depth the production and trade cycle and to calculate precisely how much capital each activity binds. (This is the required operating capital). Afterwards to analyze how each function can be redesigned to hold the minimum capital. Prerequisite for this is not to affect the value received by the customer (quality, service, after sales support, etc.). The analysis should come to the conclusion; what has to be sacrificed in order to give the company the so valuable liquidity.

The main areas which usually bind proportionally large capital are:

1.Lead time of each process

The time required to perform each process until the delivery of product to the customer often commits considerable funds. Since the credit from suppliers usually starts from the time of shipment of goods or materials, this means that the company must minimize the time of goods receipt, production, storage and shipment of products. Additionally, it should shrink the time of supporting functions (preparation of orders, invoicing, delivery, installation, etc.)

If for example, a company has average monthly sales of £2.000.000 and total lead time (as described above) 30 days, if you manage to reduce that period to 15 days, then without changing anything else it will bring the collection from the customer half month earlier that will strengthen its liquidity by £1.000.000.

2.Inventory Management

The effectiveness of the purchasing manager of a company is usually evaluated by the adequacy of materials and goods available in warehouse in order not to “run out” of at the production or the sale to the customer. This creates to the manager a strong feeling of uncertainty leading him to think how to maximize the keeping stock. This perception may change if the company plan and implement an integrated logistics system so that every function ordering, purchasing, handling, storage, etc. to source from the overall business plan and processes.

A typical example of this strategy is the automotive sector with the leading TOYOTA to maintain zero stock in materials or products. This result is obtained by applying, for several decades with great success, the system just in time / kanban. The materials received exactly at the time of entering the production process, and the products are dispatched to the distribution network exactly after their production.

Special attention should be paid to materials and products which are particularly necessary for production or for customers.

Companies in order to decrease the sense of uncertainty (until the new model works effectively), can find alternative sources of material supply possibly at a higher cost, but with direct delivery (e.g. local suppliers).

3.Management of Credit to customers

To provide credit on sale corresponds to granting equivalent loan to the customer. This decision should be made after a thorough evaluation of the client. Following old policies applied for many years, or following the competition standards can create serious problems. Consider the radical change of the banks’ loan policy (which is their job to provide loans) over the last 2 years.

The extensive provision of credit to customers creates two main problems: the reduction of liquidity (which is the oxygen for the survival for company), and the increase of risk for bad debts.

Providing credit is a privilege that the customer is receiving from the market and he cannot renounce it because the supplier has changed the credit policy. To accept the change of cooperation terms, the customer should receive a privilege of equal value. This point is crucial and usually separates solvent customers from risky ones. If, for example in exchange of credit offered to the customer a discount (volume, value, or based on purchase target), if the customer holds or can borrow the capital required to make the purchase at a lower cost, then it is almost certain that he will accept your proposal. This is sufficient to be made only for the first time, since the fund borrowed will be recycled. If for example, the said customer buys from your company £50.000 per month and enjoys a 6 month credit, the amount he needs to raise gradually over the next 6 months is £300.000 minus the discount that you will offer. If he can raise such a fund he will be able to respond to your proposal. Of course your sales will be reduced by the amount of the discount you offer to this client, but this is the cost to enhance your liquidity and avoid bad debts.

The question still stays for the clients that cannot raise the necessary capital to buy in cash or with shorter credit. Will you continue to lend them (in most cases without strong guarantees), when the bank refuses? The modern financial system offers various alternatives to the credit problem or the risk for bad debts.

The target is the reduction of credit to the customers, in order for the company to strengthen its liquidity. The design of a new trade policy with the provision of incentives to customers and the application of modern tools of credit control can lead your business in the enhancement of both liquidity and profitability.

4.Management of Credit from suppliers

Based on the above, it is reasonable to raise the question that since your company will work with this new model, so it will your suppliers? The answer is obvious. Never make the assumption that you discovered the wheel before other parties (whether they are competitors or customers or suppliers, or creditors in general). The difference that will create a significant competitive advantage in long term lies in how better you will design and implement your strategy compared to the others.

The problem with the reduction of credit from suppliers is already pushing many companies, even those that do not present any decline in their financial figures or any deterioration in their trading behavior. Consider for example how many suppliers from abroad reduce their credit or ask for additional guarantees since they consider the Greek market of high risk, or because for the same reason, their insurance companies (which provide export credit insurance) have reduced the credit limits for Greek companies.

In order to reduce the feeling of uncertainty of the suppliers, your company must maintain the proper trading behavior, since even small time delays can be interpreted by the market as a liquidity problem. Additionally, your company should develop a communication policy, through which the sense of security will be diffused towards the traders.

Even if you cannot expand or at least maintain your credit lines from the suppliers, before accepting the new terms of cooperation you should seek alternative supply sources and negotiate new discounts and benefits. Reducing the cost through this method usually is sufficient to find alternative sources of credit (e.g. through banks). Do not forget that the aim is to increase the total credit that we will receive. Many robust businesses have increased recently their bank loans and have reduced their obligations to suppliers. With this action they have not only enhanced their liquidity but also they increased their profitability, since the benefit from the discount is usually double or triple from the cost of borrowing. This is simply because their suppliers are able to raise the necessary liquidity from the banking system.

5.Management of Non-Productive assets

A very important issue for most companies is how they manage their assets and in particular the non-productive ones. In particular if these assets have been acquired with short term loans, is a shortfall in working capital that will soon affect negatively the liquidity of the company. The distinction between productive and non-productive assets in the company will present a clear picture of what assets can be liquidated without affecting the current activity. The productive assets could also be a source of liquidity using the tools offered by the financial system (e.g., sale & lease back).

Special issues

The most common mistakes companies make in managing their working capital are:

1.They link credits received from suppliers with the credits they provide to their customers. These are independent trade cycles and each firm should manage them separately. Imagine a super market to provide credit to customers because it receives credit from its suppliers.

2.They compare their performance (through economic figures) with the competition. This is correct to some extent and shows to the company what the average standards on the market are; although in many cases these comparisons are made not with non similar data (e.g. compared competitors may operate also in other markets that apply different conditions). Why thus a company, which is better than its competitors to reduce the efforts for further improvement?

3.They relax on the conclusions provided by the financial indicators, without analysing in depth the detailed information. Please note that the banks that make extensive use of such indicators usually direct their recommendations to companies. For example the liquidity ratio that compares the absolute level of the current assets to the current liabilities shows that the company has proper performance when:

(a)The higher the current assets, i.e. not only cash, bonds, but also stocks and receivables, etc. the better.

(b)The lower the current liabilities, i.e. credit from suppliers, creditors, etc. the better.

Therefore do not limit your analysis in the magic of financial ratios to manage effectively your company.

4.They do not manage effectively the guarantees they hold (property, other assets, securities, bonds, insurance contracts, risk hedging contracts, etc.) and can provide them to creditors.

5.They ignore or are afraid to use modern financial instruments offered in the financial system for managing credit, risks for bad debts and enhancing liquidity (factoring, forfeiting, credit insurance, letter of credit, etc.).

6.They do not set targets for the personnel in accordance with the enhanced liquidity model. Such a shift would create a new culture in the company and in a short time the entire organisation will operate with principle the liquidity.