Effective liquidity management critical during recession

By Odhiambo Ocholla

In this period of slow economic growth, company executives face a difficult decision: Should they continue to stockpile liquidity? Or should they start converting cash into inventory and capital investments that will position their organisation for growth.

With the current economic slowdown tight credit may shut many companies out of the debt capital markets and force them to rely on internally generated liquidity.

Cash and liquidity management is about forecasting the company’s cash needs to run its businesses and then managing the group wide cash flows, short-term borrowings and cash in the most efficient manner to ensure that those cash needs can be met.

Funding and liquidity needs are intimately connected with understanding and managing working capital and the payments and cash reporting systems. Companies could be better informed of their current liquidity position and plan it very accurately.

Liquidity management

It’s not unusual for companies to have money, but not to know where it is. Such companies might even take out unnecessary loans. This can be avoided with effective liquidity management.

But now external liquidity sources, especially banks and the capital debt markets are conspicuously open for business. Companies that issue bonds now may be able to fund future projects at rates well below market, gaining an edge over the competition.

At the same time, borrowing to raise the organisation's liquidity level presents risks. New funds will have to be invested in short-term financial instruments at rates well below the bond coupon rate.

That creates a negative spread which will consume earnings until the cash can be profitably invested in business opportunities that yield a better return.

Maintaining adequate reserves is the top financial priority for any company now because it’s your safety net during slow economic growth. During economic slowdown, companies generally avoid capital expenditures, reined in debt and hoard cash.

Many companies are now looking to expand through internal growth or acquisition. Companies certainly would keep their liquidity high and their use of debt low during the period of slow economic growth and even well into the recovery.

But now we're seeing capital expansion as companies take out more debt and convert cash into inventory so that they are ready to compete as the economy improves. Businesses are often eager to convert liquidity into inventory when they see the economy turning upward, but they need to exercise caution.

Organisations that are not ready to sink cash into capital expenditures face the challenge of investing it farther along the yield curve so that they can earn better rates than those available from short-term instruments.

Economic recovery phase

In an economic recovery phase, companies should build liquidity to take advantage of acquisition opportunities and positive-net-present-value projects. Some organisations can tap credit from banks and the capital markets to take advantage of opportunities as economy improves.

But cash from those sources is an expensive substitute for liquidity that companies generate internally.

Liquidity is simply your ability to pay bills on time and it can come from a variety of internal sources.

For example, companies can raise cash by improving their collection and disbursement processes and by concentrating idle balances from bank accounts scattered around different banks.

During the current economic slowdown many struggling organisations bolster their liquidity by negotiating or simply delaying vendor payments.

Companies can reset their payables systems to pay in two months instead of one month.

Sales typically take a real beating during the economic slowdown, and now sales growth is a top priority at many companies.

Managing working capital tightly and using the liquidity companies generate to reduce debt is still the best liquidity strategy.

With the economic outlook weakening further it’s more urgent for companies to cut debt now. But once interest rates starts going up, companies that manage their working capital well will benefit in that they will have less debt on their balance sheets to pay for at higher rates.

The current economic situation seems far from robust, and company executives must carefully weigh the trade-offs among cash reserves, debt levels and capital outlays.

The writer works with Sterling Investment Bank.charlesocholla@yahoo.com