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Home > Cash Flow Management Best Practice > Navigating a Liquidity Crisis Effectively

Cash Flow Management Best Practice

Navigating a Liquidity Crisis Effectively

by Klaus Kremers

How to Respond to a Liquidity Crisis

Once a company finds itself struggling to meet its short-term obligations, it needs to urgently access sources of cash, both internal and external. The following five-step approach covers the key elements of any response:

1. Tackle the Root of the Crisis

Normally, a liquidity crisis is only the last symptom of pre-existing root issues such as strategic or profitability crises (for example, losing one key customer contract, misalignment of product portfolio and market, a company overstretching itself by entering too many markets). A liquidity crisis needs to be addressed right away, but ignoring the crisis’ root causes will merely postpone the next liquidity crisis. In these times of urgency, the support of external advisers can bring highly needed extra resources, experience of crisis management, and an independent perspective.

2. Be Honest

It is essential that a company is honest about its current situation, and creates a climate of transparency. It must comply with any regulatory requirements to inform the market, which can be applicable to listed companies. A CFO only has one chance to put things right with the banks:

  • Give an honest assessment of the situation;

  • Communicate appropriate information to all stakeholders; banks, shareholders, employees, suppliers, credit insurers, etc. so as not to mislead, or make fraudulent misrepresentations. Be sure to present an accurate picture of the current situation; account for all received bills (from experience, purchase ledgers do not include all received invoices, with many invoices hidden in staff drawers).

3. Gain or regain trust

Regaining the trust of banks, shareholders, and other stakeholders is a prerequisite to maintaining, or raising external funding. This requires communicating robust and realistic plans, delivering on these plans and building relationships.

  • The main tool for trust building is a bullet-proof rolling liquidity forecast on which you will deliver (see Rolling Liquidity Forecast).

  • In a liquidity crisis, a company’s usual banking relationship can be replaced by a workout banker with different expectations and greater experience of liquidity crises.

4. Harvest Cash

There are three main ways to improve cash position:

  1. Collect and control existing cash

  2. Reduce working capital

  3. Restructure the balance sheet

4.1. Collect and control existing cash

Companies usually have large amounts of cash spread across business entities and regions:

  • Know where the cash is and who is responsible for it;

  • Establish cash pooling: minimise cash held by operational entities (no cash constraint on operational entities means no tough cash discipline);

  • Make managers ask for cash if they want to spend;

  • If the company has one main bank lender, try to keep all the company’s cash within this bank, to increase transparency.

4.2. Reduce net working capital

Working capital reduction obviously uses three levers: receivables, inventories, and payables. Keep some key points in mind while reducing working capital:

  • Fix a deadline for finalizing collection and deciding on write-offs for receivables;

  • Promptly claim refunds of taxation, if due;

  • Reduce inventories by both reducing replenishment of production inventories, and by selling low-rotation inventories to generate cash;

  • Be careful when extending payment conditions for suppliers, and keep in touch with the credit insurer—if they pull the cover, the company would have to prepay its suppliers, with disastrous consequences for its liquidity.

The potential for reduction in working capital is also very much industry-specific, depending on the make-up of the industry’s working capital requirements. For example:

  • The construction industry has far greater potential for cash realization (up to 20% of working capital employed) than the oil and gas industry (far less than 10% of working capital employed).

  • This difference is from the type of long-term contracts normally used in the construction industry, creating significant work in progress and inventory balances.

4.3. Restructure balance sheet

Restructuring the balance sheet is a medium/long-term option, and usually involves third parties. Three main approaches exist:

  1. Reduce investments: short-term solution of freezing or cancelling investments:

    • Before freezing expenditures, critically analyze impacts on future earnings;

    • Investments should be modular as far as possible, so that if a project is curtailed or postponed, the investment already made is itself still viable;

    • The cash return on investment should be a maximum of three years for generic industries (longer for asset intensive industries).

  2. Sell fixed assets: medium/long-term solution. A liquidity crisis gives the opportunity to redefine the core businesses and sell non-core activities:

    • Selling assets always takes much longer than planned—consider it an upside rather than part of the main solution;

    • Within the core business, consider the sale and leaseback of assets.

  3. Raise debt and/or equity: medium to long-term solution. This approach may seem the easiest solution, but at the end of 2008, banks reduced credit lines, and stock markets closed to capital increases.

  4. Following the aforementioned steps will better enable the company to raise finance in the future. Remember, too, that keeping the supplier insurers on side and informed indirectly generates a source of credit through creditor balances.

5. Manage Cash Sustainability

Finally, a company needs to ensure a sustainable liquidity position. As mentioned above, strategic and operational root causes for the last crisis must be understood and tackled to avoid reoccurrences of liquidity crises; then companies can implement the following techniques to keep control of liquidity:

  • Implementation of KPI-based management that includes liquidity and capital tied-up indicators.

  • Active risk management of the business, including operations, legal contracts, financing decisions and structure, investments, and image/reputation. For example, a European pharmaceutical company lacking cash flows decided to finance a €8Om factory with short-term loans. Due to poor performance, banks decreased the credit facility, causing a liquidity crisis which forced the company to restructure.

  • Change of the company culture:

    • Encourage staff to take care of the company’s cash as if it were their own;

    • Encourage realistic forecasts and planning: use scenario modelling techniques to limit future surprises;

    • Change employees’ incentivization (long-term focus).

  • Ongoing communication with internal and external stakeholders to further build trust and confidence.

  • Continuous implementation of a “tool box” of operational measures to optimize cash management, working capital, and information accuracy.

  • Further operational, financial and strategic flexibility to enable the company to react early and quickly once issues become apparent.

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Further reading

Books:

  • Blatz, Michael, Karl-J. Kraus, and Sascha Haghani. Corporate Restructuring: Finance in Times of Crisis. New York: Springer, 2006.
  • Graham, Alistair. Cash Flow Forecasting and Liquidity. Chicago, IL: AMACOM, 2001.

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