​​01 Liquidity Risks

Liquidity is closely linked to credit, market, and operational risks but often received inadequate attention. Many corporates have their primary focus on operational matters while neglecting the hidden liquidity risks.

Working capital is the most critical issue of liquidity management. Before problems occur, corporate management needs to answer the following questions:

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• ​Is there sufficient working capital to protect the company against deterioration in the quality of current assets?

• If a large portion of the company’s accounts receivable is uncollectible, could the company still meet its obligations? 

• What is the quality of inventory, e.g., is it obsolete?

• How much does the long DSO affect the cash flow? How can the DSO be shortened?

​Inventory 

                (Current Assets – Inventories)

                                or Quick Assets 
Quick Ratio = ----------------------------
                             Current Liabilities 

International benchmark for quick ratio is at least 1.0. Inventories should be viewed somewhat sceptically as an asset. 

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• Value of inventories is often overstated on the balance sheet.

• Inventories tie up capital

• If inventories grow faster than revenue, cash flow will be in trouble.

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DSO -

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The DSO number shows days outstanding after a company sells its product to customers on credit and waiting to collect the money. It is calculated as follows:

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            Total Credit Sales
DSO = -------------------   × No. of Days
          Accounts Receivable

By quickly turning sales into cash, a company has a chance to put the cash to use again more quickly. A high DSO number shows that a company needs to for a long time to collect the money. This can lead to cash flow problems. A low DSO means that it takes fewer days to collect its accounts receivable. That company is promptly getting the money it needs to create new business.

It is strongly recommended that a company set up an IT system to monitor the average length of time that the company’s outstanding balances in relation to the cash flow. The system shall also track company’s DSO over time to determine if its DSO is trending up or down or if there are patterns in the company’s cash flow history.

There are two vital points for liquidity risk management. One is a system that integrates cash, profit, and loss. The other is forecasting. Forecasting is the early warning apparatus the business really needs in a rapidly changing economic environment. The best way is to integrate cash and profit and loss and forecast the outcome in several critical areas that the company must be well prepared for with effective solutions.

It is suggested to investigate the following areas:

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• Liquidity : Many companies would have long or mid-range planning for adequate liquidity in the process. However, as most cases turn out the more important exercise in liquidity risk management is the forecast of cash, profit, and loss in the shorter term especially during a deteriorating economic environment.​
   

• Business model: A well-established system of integrated forecast will assess the impact of sales and costs on liquidity. It will also serve as an early warning sign of those would-be problems so as to help management be prepared for internal and external solutions.  By integrating cash, profit, and loss in the system, the forecast will be able to Identify as early as possible whether an impact on the business is short-term in nature. It also sends out signal alerting whether the impact is on the long-range fundamental issue, giving management sufficient time to consider the best chance of adapting.
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• Short-term targeting: account receivables. As often turned out, account receivables have the most significant impact in nature of short-term liquidity management. In the system of integrated forecasting, management can set account receivables as short-term targets for identifying risks and prioritising collection. 

Cash can exist in many forms. From real cash in the pocket to cash in the bank, lines of credit, loans and bonds to inventory, debtors and creditors. All of these represent different types of cash. We call anything that isn’t actual cash as proxy cash, which shows in the transaction accounting systems and is mixed with accrual accounts type accounts. To better manage the continuum of cash, it is suggested to build an integrated system to keep track of the daily cash flows in various accounts so as to demonstrate a clear situation of both real and proxy cash.

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Read More: Cash-flow Funding Model