Within the financial services sector, liquidity risk is closely monitored by sector regulators to avoid jeopardizing the stability of the sector and the economy at large. Central banks around the world require that banks maintain a certain level of liquidity in order to meet expected and unexpected withdrawals from customers. The destructive nature of liquidity risk in the financial services sector to the economy was experienced in the 2008 global financial crisis when banks such as Northern Rock were unable to secure funding from the interbank market.
Outside the financial services sector, liquidity risk should also be a primary focus for CFOs and finance managers due to its compounding effect of causing other risks such as market and reputational loss risks. In the mainstream business world, this risk is referred to as the funding liquidity risk; and it occurs when a company is unable to pay its liabilities that fall due in less than a year due to insufficient current assets. Current assets in this context refer to cash in bank or assets that can be quickly sold in the market to provide the needed cashflow within one year.
Business Operational Cycles Alignment
The major causes of funding liquidity risk are poor cash flow management and lack of proper cash flows prioritization. Businesses need to hold onto a sufficient amount of cash; and manage their cash conversion cycles diligently to ensure they maintain optimal liquidity levels at all times to meet their immediate cash flow requirements.
Businesses with predictable operational cycles should prioritize building their cash reserves during down times; in order to ensure that they have cash readily available to meet their short term liabilities when at the peak of their operations. To do this, cashflows need to be projected keenly to foresee any cash demands in the future. For example, primary agriculture companies should build a cash reserve with a 6-month cover as their businesses depend on cyclical weather patterns. During the harvest and sales season, such businesses should ensure that capital and any other expenditures are within budget; with a focus on building cash reserves to be deployed during the planting season
Cash Conversion Cycles Alignment
Another way that business can expose themselves to funding liquidity risk is by having long cash conversion cycles (CCC). This is the period that a business takes to convert inventory into cash in bank. Inventory needs to be quickly converted into cash as keeping inventory for a long time comes with its own expenses such as storage fees. Alternatively, these storage spaces could be used for other productive functions. Effective marketing departments and just in time production in supply chain management help in reducing the cash conversion cycle. The priority for the business should be to always have enough cash to meet its short term financial obligations; as opposed to having excess inventory that inflates its balance sheet but constrains its liquidity.
Management should ensure the terms extended to customer and suppliers favor the cash levels of the business. Accounts receivable days is the time period that a company takes to collect money for goods and or services supplied to its clients on credit. This time period should be shorter than what it takes for the company to pay its suppliers who provide goods and or services on credit. The principle behind this is that the business should hold on cash for longer before paying out to suppliers. To achieve this, the business should prioritize expenses based on importance and when they are due for payment.
In a manufacturing business setup, cash already received should be used to pay off pending highest priority expenses such as raw material suppliers or salaries; and for the raw material suppliers, prioritize those whose payments are due earliest. A good practice is to develop an accounts payable report and compare it with accounts receivable report in order to project which expenses will take a priority once receivables are converted to cash.
Be Intentional In Liquidity Risk Management
Just like all other major financial risks, failure to manage funding liquidity risk could be devastating to a company due to the risk unlocking a series of other related business risks. For example, companies looking to sell assets quickly in order to meet short-term liabilities end up facing market risk as they become unable to sell their assets without discounting them in the market. On the other hand, the company could end up losing credibility among its suppliers in the value chain for failing to honor payment promises and loose its reputation among them. It is therefore, necessary to manage funding liquidity risk and set up structures within the finance department for monitoring the same using financial ratios such as the current and quick ratios.
Author: David Kageenu