|Posted by Percy A Lowe on July 20, 2013 at 6:30 AM|
by Frank Coker
If you have enough money to pay your bills plus take-home pay for the owner, isn’t that enough? Unfortunately it’s usually not that simple. Just covering monthly obligations is not enough. For most businesses, revenues bounce around from month to month, and so do expenses. Even a very profitable company is likely to have times when revenues dip below expenses. And that’s why we care about liquidity. If you don’t have adequate liquidity (weather proofing) you can get blown away when the big “financial storm” comes your way. And storms are inevitable.
Liquidity is all about your ability to pay your current debts with available resources. If you have more short term liabilities than resources to pay them with, your company is considered illiquid and you are seen as a bad risk by banks and investors. If you have more than enough current resources to cover current liabilities you are considered to have positive liquidity and probably a good candidate for financing.
Banks are often criticized because they don’t want to loan money to companies that need it the most and ironically all too happy to lend money to companies that need it the least. But this view actually misses the point. If you wait until you desperately need money to seek help from a bank, it’s the same as waiting until the storm arrives and then deciding to repair your roof. This raises a big question about the wisdom of the owner. The best time to fix a roof is when the sun is shining and the leak is not causing a problem. Not on a rainy day. It makes sense that banks don’t like to lend to companies that wait for a rainy day. They much prefer to lend to the smart companies that get their house in order when the sun is shining.
The best storm protection, from a business perspective, is to build financial reserve capacity when business is at its best. That’s the time to get bank credit lines established and if possible, pay down the most expensive debts. Think of this as fundamental money management.
Far too many companies simply ramp up operating expenses when things are going well and then discover that they can’t sustain these expense levels when revenues take a dip. In worst case, businesses get caught in a liquidity squeeze during revenue dips that they might not be able to dig out of even when the business returns to top performance. So this is where we need to apply some math to make sure that a good balance is being achieved.
An ideal liquidity goal for most businesses is a current ratio (total current assets divided by total current liabilities) that is greater than 1.5. Once it goes below 1.0 it is time to be concerned. If a company has a current ratio below 1.0 in “good weather conditions” it is highly unlikely that it can handle a storm that will drive this number even lower.
So far this discussion on liquidity has been very basic. To take this up a notch, there are several more layers in managing liquidity and storm proofing your company that should be considered. For example, there are several liquidity elements that do not live in your accounting system such as your company’s line of credit, credit cards and other available borrowing capacity. Technically, your available and unused credit is an available resource that is just as good as cash. We can add this to current assets to get a better understanding of available resources. But when we start including borrowing capacity in the liquidity calculation we also need to look at major payments that lie ahead that must be paid but may not show up yet as current liabilities. This could include up-coming tax payments, major credit installments, balloon payments, and other creditor payments that are not already included in current liabilities. This is the level of detail that some lenders will require in order to approve a loan.
We are in the process of adding a liquidity analysis capability to Corelytics so that we can see what a bank sees when they evaluate a company for a loan.
With this picture in mind, do you think your company is ready to handle the next storm? Are you monitoring your business metrics so that you know you have adequate resources to withstand a surprise storm?
Categories: Small Business Managment