Liquidity Examined

A lender can look at the current portion of a balance sheet, which tells us assets that are cash or will be turned into cash in the next year and liabilities that must be paid within the next 12 months with cash.  Lenders also can run the current ratio that compares current assets to current liabilities to tell if the company has cash resources to satisfy its short term obligations.

This review is good to do, but it is possible for the lender to think the company is in good shape, when actually there is a liquidity crisis at hand.  Thus, liquidity must be inspected further to make sure that the liquidity is true and not an illusion.

One area is concentration risk.  Receivables should be reviewed for any concentrations to one or a small group of buyers.  If a customer were to fail while owing a lot of money to your borrower, it could have a disastrous impact and the company may see current assets vanish before their eyes.  Also, inventories should be looked at.  If there are products that are stockpiled and do not have a ready market, turning those products into cash may be impaired or the item may have to be discounted to move it.

Verifying inventory or accounts receivable are is also important.  Just because your auto dealer says he has a certain inventory of cars or your farmer says the grain is in the bin, is that actually true?  Inspections are a must if you have a substantial loan that is based upon inventory as the source of repayment.

Another factor that will impact liquidity is what methods of risk management are your customers using?  If you have a farmer with crops of livestock, are these subject to a contract price or are these items subject to market volatility?  How stable are the inventory prices?  Can you take the figure to the bank or is there a possibility that when the inventory is sold, less cash will be realized than what is reported on the balance sheet as inventories?

Timing is an important factor for current assets.  When will the receivables become cash?  Are any taking longer to collect than usual?  If that trend continues, there is more of a need of working capital to support operations.  One possible strategy is to look at a month by month projected budget or statement of cash flows to see when cash expenditures will be paid and when cash revenues will be received.  This is necessary when determining what an appropriate level is for a line of credit.

The quality of inventory is also a key factor to watch.  Crops will command a premium or be subject to a discount based upon items like the moisture content.  Organic crop may be sold at a higher price than a conventionally grown crop.  Also what does your producer do with a GMO crop if China places a ban on buying GMOs?  This can push down the market price of the grain your farmer has.

Insurance is an important factor to consider.  If the borrower is under-insured, a catastrophe could be a severe drain to the cash available for operations if inventory is ruined.  Another factor to consider is does the company have adequate insurance to overcome a peril and continue operations or will there be a business disruption?

Looking at the level of the line of credit is an important judge of liquidity.  Is adequate inventory or receivables available to retire the LOC?  If not, how much will be left over and how much additional drain on cash will the remaining balance cause?  This is a reason to manage a LOC with a borrowing base.

The level of cash is a final determination in figuring the true liquidity.  Cash does pay the bills but the question is how much cash is necessary for the company to operate.  How does the balance in the bank compare to the requirements for operations, major expenses, and debt service?  Comparing cash to these expenses can determine the burn rate of cash.  This calculation can be essential to seeing how long a company can weather a downturn.

So all liquidity is not created equal.  Some items don’t turn into cash as quickly as the company may need this for operations.  A closer inspection will help the lender understand how solid the liquidity numbers actually are.