All companies have liquidity risk. Some firms see it as essentially cashflow management, whereas others see it as purely managing the bank account. Liquidity is right at the heart of the risk management concerns of any business. Companies need funds to pay their bills, to pay for the goods that they will turn into finished goods, to pay their staff and to pay for other costs that they incur. These include capital purchase, taxation and bonuses, as well as other more routine costs.
Liquidity planning looks at the expected outflow and inflows that the company is expecting and tries to assess whether there are gaps that need to be addressed. Typically, the assessment looks a bit like this:
| Inflows | Outflows | Net Position | |
| 0–7 days | |||
| 8–14 days | |||
| 15–21 days | |||
| 21–30 Days | |||
| Month 2 | |||
| Month 3 | |||
| Later |
The problem is getting the data. Of course, the availability of funding to a company depends upon the nature of the facilities that it enjoys. These will form a number of options including utilization of existing undrawn facilities. It is when comparing the net position to the available facilities to identify whether there is sufficient available funding, which is at the heart of such cashflow management.
At its most basic, the calculation is as follows:
| Opening bank position: | X |
| Add cash inflows | X |
| Deduct cash outflows | (X) |
| Net position | X |
| Available undrawn facilities | Y |
So long as Y exceeds X, the company does not have any immediate cash flow problems if the modeling is reliable. However, there are difficulties and other uncertainties, which is why cash flow management and the management of liquidity are such a concern.
In financing itself the company will initially use equity capital and reserves together with finance from the founders often in the form of a loan. Later they can take out loan facilities and extended overdraft facilities as well as issuing bonds which are traded debts with an agreed redemption date. They can also keep reserves rather than distributing them to shareholders in the form of dividend. Liquidity risk management needs to look at the likely market in which options need to be assessed and then consider which option has the greatest likelihood of success.
Accounting records maintained by a firm are generally contractual. They show invoices raised and received and their due dates. These are the contractual dates. Taxation has a set date to be paid, as do salaries, credit card bills, suppliers’ invoices, rental charges and other amounts.
However, the actual date on which these will be paid may differ significantly from the original due date.
The contractual payment profile may not equate to the behavioral payment profile that actually reflects what happens. Indeed, customers may not pay on time or might pay early. Such delays in receipts (and of course, there may not actually be a final receipt leading to bad debts) can cause a firm major problems. The behavioral analysis considers what has historically happened and uses this to estimate what the likely position is going to be at the end of any period.
Therefore, liquidity risk management is at its best when it is essentially real-time. There is not a lot of point in knowing that you will have sufficient funds at the end of a period if you do not have the funds during the period to make a payment that is due. Consequently, liquidity risk management continually is assessing the accuracy of the assumptions that are made and taking these into account in their liquidity planning process.
In managing liquidity, there are a number of available tools that can be considered. The first of these is effectively managing the business by actively considering which customers you choose to accept and trying to balance your portfolio appropriately. Ideally, this portfolio management approach will take into account the types of customer that the company has and try to build these into a series of pools. Within these pools, the risks should be essentially similar (or homogeneous).
The objective of liquidity risk management is then to try to balance the portfolio such that if one type of client has financial problems, another is in a better position, leaving the overall cash flow expectations unchanged. This form of portfolio risk management manifests itself in target market analysis, with the company seeking out clients that actually offset other client risks that currently exist within its business.
In deciding upon the facilities that the company requires, they will also need to be consider long-term capital planning. That is raising long-term finance through either the issuance of either equities or bonds. There are again cash flow implications of the choices taken. If a company issues equity and sells it in some way, there is no requirement for redemption, but there is an expectation of a payment of a dividend. It is important to note that the dividend could be passed and if this were to occur, no servicing costs or cash flow implications would result.
If a company issues bonds, they will again receive the cash inflow upfront. However, there is now a definite servicing charge, represented by the coupon on the bonds. There is also a redemption profile set out in the prospectus for the sale of the bonds. Some bonds could be cumulative such that if a coupon is missed, they are paid later, but these are relatively rare. Clearly, both the coupon and the redemption would impact upon cash flow, and consequently, liquidity risk.
Such capital planning is generally long-term although many firms issue bonds every month and operate what are essentially revolving facilities.
The capital planning will also need to take account of the expected investment environment and the position of the underwriters. When a company issues bonds or equities, it will hire an investment bank and an underwriter. The underwriter will take the key risk on the transaction in exchange for a fee. Once they have signed the underwriting agreement, the company knows the amount of monies that it will receive. If the transaction actually fails and nobody actually wants the bonds or the equity, then the underwriter ends up with all of the assets and has to sell them on later.
But there is always a but. Even though the underwriter has signed a contract and a price has been agreed, if the market conditions are so badly negative that the transaction is likely to fail, the transaction will generally be pulled. That will mean that the company will not receive the inflow of funds that it anticipated and this could result in major problems for the firm.
That is also why firms have a range of other facilities on which they can call. These include the following:
- Loans
- Overdrafts
- Credit cards
- Invoice discounting or factoring
- Leasing
As always, there are additional problems here. All of these forms of finance carry some type of coupon that the company will have to pay. These eat into the undrawn facilities and result in less funds being available. The loans need to be repaid, something that many firms appear to forget. This includes credit card debt, which is used by many small and medium-sized enterprises for short-term funding.
Invoice discounting and factoring are rather different, by nature. They are essentially designed to enable the company to obtain access to funds on sales earlier than would be the case with normal contractual terms. Of course, there is always a fee for such a service and this is normally built into the funds that the company actually receives.
Facilities are clearly great. They enable a company to trade, knowing that they have the strength of a financial institution behind them. The problem is that the company that does not need facilities can get them and the one that is struggling has facilities removed. That is a problem for cash flow management. The assumption that your financial institution will honor a facility is probably a brave assumption. If a company has a problem with one facility, then often it finds that all the other facilities on which it is relying will be either restricted or withdrawn. This can be extremely frustrating and ultimately may cause the failure of the firm. So undrawn facilities are extremely useful, but it is not correct to assume that they will always be available when they are needed just because they have been agreed to.
The next stage is what are referred to as contingency funding arrangements or plans. These are detailed arrangements which are only activated when the company requires them. They are mostly used by major financial institutions and corporates and are required by banking regulations.
As always, there is a problem. Your firm has contracted to provide contingency funding arrangements for a company and received the relevant fee. The customer then gets into difficulty and calls on you to provide the funding agreed within the contingency funding plan. The provider of the facility is then often left in the position of considering whether the company will fail with the funds provided by the contingency funder or without these additional funds. Of course, the receiver to the failed company might take legal action, but that can be addressed later. My problem with contingency funding plans is the lack of evidence that they are actually effective in practice.
Another issue regarding liquidity risk is for companies that have excess funds. They can either invest these funds into assets, which might provide a source of high quality liquid assets, or they could put them into bank accounts. Bank accounts currently pay very low or limited return, what is essentially a discount to real returns, so can be unattractive. Bank accounts are clearly liquid and might be considered as a low-risk, low-return alternative to investing in other assets. Because of this, many firms go seeking return by investing excess liquidity into other types of financial assets that provide a higher return than the bank accounts. Clearly, the higher return, the higher the risk that the company is taking.
Liquidity risk now considers a number of matters. First, there needs to be an efficient two-way price for any asset acquired that underpins the asset value, based upon prices published by active market makers. If a financial asset ceases to be traded, then its value might become uncertain or limited. While illiquid assets including private equity could generate superior returns, these cannot be guaranteed.
Second, liquidity fund management needs to consider the differing economic environments and their impact upon the asset liquidity. Put at its most basic, if a lot of companies are using similar assets as a stock of high-quality liquid assets, then under adverse local conditions, they will all sell them at the same time. This dumping of the assets onto the market causes a collapse in asset value due to the unbalancing of supply and demand. So, it is necessary to not only consider the high quality liquid assets that you are holding, but to consider them against a variety of economic scenarios.