Avoiding a Liquidity Crisis from Becoming a Solvency Problem
Any size and type of business can have a liquidity crisis.
Liquidity can be defined as the ability of a business to pay their current financial obligations, which requires converting assets, such as, accounts receivable, inventory or services provided into cash as quickly as possible. Cash is the most liquid of all assets and is used to pay current financial obligations and purchase capital assets.
Liquidity can be measured in numerous ratios (Current Ratio, Quick Ratio or the Acid Test Ratio), though the most straight forward ratio for measuring a business’s liquidity is the Cash Ratio.
Cash Ratio = Cash + Cash Equivalents (Short Term Investments) / Current Liabilities
If the Cash Ratio is greater than 1, a business could be considered at this moment in time liquid and currently solvent. A Cash Ratio of less than 1, the business maybe having a liquidity crisis.
An accurate Cash Ratio can be computed at any time, (middle of the month, month end, a week before payroll is due), if the financial records are up to date and current liabilities are all being accounted for correctly. Current liabilities can be adjusted (topside in a spreadsheet) to include payables that have been incurred, but still need to be input to accounts payable or items that need to be put on the balance sheet in the current liabilities section by a journal entry. In addition, if owners are being paid through draws this amount should be included in the current liabilities.
It is important to have a real current liability number as the denominator of the computation as it is key to having a meaningful Cash Ratio.
To ensure that the cash and cash equivalents (the numerator of the Cash Ratio) is correct, make sure that the bank accounts are being reconciled on a monthly basis and that deposits are being made daily. Also, make sure that the Cash Ratio is computed using the general ledger cash balance versus the bank cash balance which may be overstated due to outstanding checks.
Generally, a business with a liquidity issue will see their current liabilities (the denominator) grow faster than cash and cash equivalents initially. Accounts payable, payroll and debt obligations never go away they just keep building, especially when a business starts slow paying or stops paying their bills. The act of stopping to pay bills may work for 30 to 45 days, but if a business stops paying their bills for over 60 days the liquidity issue will become magnified as accounts payable increase and the cash in the business is being used to pay fixed expenses such as, rent, utilities, payroll and payroll taxes.
If the business is at the point where solvency is now a question, management needs to act immediately on the liquidity issue. Business management and owners need to focus on how quickly the business can generate cash, as cash is the key to improving and resolving the business’s liquidity crisis.
Business management and owners can increase cash inflows and lower cash outflows by:
- Accounts receivables collection – focus on getting DSO below your industry’s standard or below 30 days. This means calling customers with past due invoices and sending out monthly statements with handwritten notes on the statement with past due amounts.
- Tightening the business’s credit terms to net 15 or due upon receipt.
- Put customers on credit hold and cash in advance with receivables over 60 days or greater.
- Work out payment terms with customers that are having liquidity problems, which may include the customer agreeing to weekly payment terms in writing and paying for new orders cash in advance. No COD orders.
- Turn customers that are over 120 days past due, no longer buying from the business and refusing to pay their past due invoices over to a collection agency. No business needs or wants a customer that never pays their bills.
- Collect all receivables owed to the business by the owners.
- Stop all employee advances.
- Cancel or collect all employee credit cards.
- Sell off all unproductive assets, at any price.
- Take inventory purchases as close to on demand as possible without shutting down the production line. This may require cancelling or postponing recurring purchase orders with vendors.
- Review all vendor pricing to ensure that the business is getting the best price.
- Sell off slow moving and obsolete inventory, at any price. Management needs to face the reality that no customers want their slow moving and obsolete inventory and the longer the business holds on to the old and obsolete inventory the more worthless it becomes.
- Review the gross margin on all the products the business is selling to ensure that all products are generating at least 20% gross margin. If possible, exclude freight costs from the gross margin analysis.
- Start charging for freight and shipping on low volume and low margin orders.
- Stop all capital expenditures.
- Cancel any operating leases that have limited cancellation fees.
- Start an email marketing campaign for the business’s products and services. Email marketing is a cheap way to let customers know what is for sale, such as, old and obsolete inventory. Most importantly; marketing emails show your customer that the business is still open for business!
- Force employees to use any type of PTO (personal time off) and vacation pay before implementing a work force reduction. This will help avoid having to make large lump sum PTO and vacation pay out if an employee is laid off. Please check with a labor attorney before implementing this process as laws vary by state.
- Reduce operating expenses – NOW! This means making tough decisions and implementing those decisions quickly. Review all variable expenses and determine what variable expense can be reduced or eliminated. This may include reducing employee hours and laying people off, stopping all non-essential travel, all business entertainment expenses and even charitable contributions.
Business management and owners need to focus on getting cash in the bank and making tough decisions today versus waiting until tomorrow. Hopefully, implementing these types of cash generation and cost saving strategies early in a liquidity crisis will help the business to pay off its debts timely and be more profitable in the future.