Not uncommonly, a liquidity crisis emerges quickly and suddenly. It pulls the affected company into severe struggle and threatens the continuity of business operations. Credit interests and repayment obligations can no longer be serviced, suppliers cannot be paid for purchased production materials, and wages and salaries are not completely transferred to its employees at the end of the month—to name just a few examples.
In simplified representation, we can speak of a liquidity crisis as an organization’s risk of over-indebtedness, or insolvency, in the near future. Such a scenario can literally happen overnight, for instance, due to the illiquidity of a major corporate client that must default on its debts to the company. This especially applies to smaller enterprises whose financial resources are very limited. They might severely struggle with such bad debt losses and face problems to initiate actions aimed at releasing liquidity within a short period.
But more often, financial difficulties develop slowly and are reflected in the following signals:
- Loss of regular customers and a slump in sales (25% and more), unsold inventories increase significantly.
- Customers, if at all, only pay late (> 90 days). This is marked by high accounts receivables (> 10% of sales revenues) and intensified bad debts (> 5% of sales turnover).
- Extended utilization of terms of payment, which culminates in complete default of payments to suppliers.
- Suppliers are only willing to deliver goods ordered under poorer conditions of delivery, which means shortened payment dates, or shipment against appropriate securities and/or pre-payment.
- Servicing the organization’s bank credits becomes a great challenge.
A liquidity crisis most often results from wrong decisions made in the past (undesirable developments on a strategic level), and is tantamount to the consumption of assets and potentials (ultimately jeopardizing success). And, as we have seen, there are several early warning indicators pointing out to potentially emerging financial problems.
But, unfortunately quite often, liquidity troubles are not detected until the company is already in the middle of a liquidity shortage. To amplify the existing negative effects further, liquidity crises can additionally turn into some kind of vicious circle. If, for example, suppliers are not paid, they might refuse to provide materials mandatory for production. This hits the company’s entire manufacturing process. This, in turn impedes cash inflows from further sales processes.
Thus, especially to give small and medium-sized entities (SMEs) some thought-provoking impulses, we will mainly focus on the following question in the next sections: What are the key figures that are suitable for SMEs to diagnose life-threatening liquidity shortages within an adequate amount of lead time?
A potpourri of liquidity metrics
Existing economics literature provides a great batch of figures to measure liquidity. Unfortunately, many are less appropriate to function as identifiers for liquidity crises. This is based on two reasons: On the one hand, they depend too much on the balance sheet and income statement. As a result, there is only a numerical view of the past, based on an outdated valuation (e.g. in terms of inventories, payables, and accounts receivables) at the time of the KPI analysis.
And on the other hand, due to the often quite interpretive nature of specific accounting guidelines and regulations (financial options and discretionary powers), the financial statements reflect a distorted picture about the company’s financial situation.
Therefore, in the following paragraphs, we will introduce several figures that can determine and measure the organization’s entire cash flow by using management accounting’s monthly updated and distortion-free data material.
The free cash flow (FCF)
Simplified, the cash flow figure shows the amount of money that is left behind after deducting operational expenses from (regularly) occurring cash inflows. So, cash flow is a direct indicator of an enterprise’s earnings and financing power—or, in other words, the ability to generate financial resources on its own.
For this calculation, only those values are included which are directly linked to the actual flow of money (this excludes depreciation and amortization, additions to/releases of provisions, or increases in work-in-progress).
Whether the company is able to generate sufficient financial resources to cover its current expenses, based on its regular sales activity, is described by the operating cash flow (OCF).
Cash generated from goods and/or services sold to the customer base or from accounts receivables against customers
+ Cash inflows from extraordinary items
+ Other cash inflows not based on an investment and/or financing activity
− Payments to suppliers for materials and goods
− Cash paid for wages and salaries of the personnel employed
− Cash outflows for extraordinary items
− Other payments not based on an investment and/or financing activity
= Operating cash flow (using the direct calculation method)
High current cost levels and sales revenues that break off—typical signs of an emerging crisis—lead to an increasingly negative OCF over time. Even though the latter is not necessarily connected with direct payment difficulties—just to think of the temporary funding of business operations from the company’s cash resources, or rather other sources of financing—it can be seen as an explicit warning signal. In the long term, hardly any company will be capable of surviving without being able to generate cash inflows from its current sales activities in its market(s).
The investment cash flow (ICF), however, is a business ratio that deducts the cash outflows for investments from the cash inflows resulting from disinvestment measures.
Cash generated from the disposal of tangible and intangible assets
+ Cash inflows from selling shareholdings and financial assets
− Cash paid for the purchase of property, plant and equipment, and intangible assets
− Cash outflows from the acquisition of shares and financial investments
= Investment cash flow
The sale of fixed assets is often used for gaining liquid funds quickly. This frequently results in negative consequences for the operational business activity in the medium or long term. Thus, a very high, positive ICF can be (not has to be!) an indicator that urgently needed liquidity has been collected solely by flogging the family silver. This can then no longer contribute to the operational success and performance thereafter. Therefore, the company should come up with a detailed solution or strategy on how to generate sufficient returns from its operating business again, necessarily before the realizable assets have been sold entirely.
The free cash flow (FCF) ultimately results from the connection of OCF with ICF: OCF + ICF = FCF
This figure illustrates whether the analyzed organization has an adequate amount of financial means from its operational business activities, and still has one after investments have been made. The remaining cash can be used, for instance, to realize dividend payouts to shareholders or to pay off outstanding loans. Consequently, a negative FCF regularly means that the company is in an acute liquidity crisis and is not able or willing to bail out its unprofitable operating business with disinvestment, or rather, the disposal of assets.
In this context, the cash burn rate (CBR) details how fast the money is “burned” within the organization—or in other words, the time it will take for finances to dry up and illiquidity to occur.
CBR = (Monthly) Liquid Funds / FCF
Average time needed to balance accounts payable/receivable
“When do we pay incoming invoices from suppliers on average? And, what is the average time span until our customers meet their payment obligations”?
Average time to balance accounts payable = (Trade payables on average / Expenses from materials and services purchased) * 360
That figure represents the time it takes the company to pay its incoming invoices on an average. A prolongation of that term over time is a possible indicator of imminent liquidity shortages. This results in a postponement of the terms of payment while preserving liquidity.
After a company’s current liquidity crisis has become public, it might be possible for the situation to get worse. Suppliers possibly shorten the time for payment allowed or only provide their goods to the company if payments are made in advance. Needless to say, this further weakens the organization’s liquidity situation.
Average time to balance accounts receivable = (Trade receivables on average / Sales revenues) * 360 * (1 / (1+VAT))
The business ratio above allows for deeper conclusions about the customers’ payment behavior. It is an indicator of the time span needed until sales revenues are transformed into current liquidity. So, extending periods can express poor payment habits of the company’s consumers, which, in turn, might have their cause in economically strained times, for instance.
Besides, a prolongation of that interval might also result from short-term sales revenue tactics. To increase its pursued sales, the enterprise simply and intentionally accepts supplies to consumers with poor creditworthiness, thus, running a greater risk of default. Measures like granting higher cash discounts, as well as tightening up of operational dunning processes, can be used to shorten the time span until customers’ payments.
Inventory turnover rate of finished goods
The business metric of the inventory turnover rate provides an insight into the frequency a product’s stock has been turned over on an average within a defined period (product’s complete sale out of stock and replacing it with newly produced goods).
Inventory turnover rate = Costs of finished goods sold (net sales) / Average inventory (measured at purchase prices)
Each kind of storage, under an economical perspective, represents tied-up capital that the company cannot use for other purposes. A low inventory turnover rate of finished goods is similar to a high amount of fixed capital because of full stock. Furthermore, goods like perishable food or rapidly outdated technical components are concerned with the threat of losses in value in case of belated sales resulting in lower return on sales (inevitable price reductions, and so on) as well as less cash inflows.
As time goes by, companies affected by liquidity crises regularly struggle to sell their products, making it necessary to increase stock. As a consequence, financial means are tied-up in inventories and liquidity potential is wasted. Therefore, on a case-by-case basis, it should be thought about whether a reduction of high stocks via, for instance, rebate campaigns that incentivize increased sales, is doable and reasonable. Although such measures lead to an undesired loss of earnings per customer, it might be possible to over-compensate this with positive liquidity effects.
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