Financial health of the corporation - A closer look at liquidity risk
BY: SHEPHERD SHAMBIRA
The previous article gave insight into the factors critical in assessing the financial health of the corporation. One of the factors mentioned is liquidity risk and its role in determining failure or success. There is a saying which states that “the customer is king”. I wish to propose that in business “cash is king”. If you have cash and when you are in control of cash generation capacity and obviously expenditure, there is no reason why you can not be the king of business. This article seeks to discuss the nature of liquidity risk and its associated challenges.
The general form of liquidity risk is the inability to settle obligations as they fall due. This can be due to a number of reasons. For example, a company may have debtors which are due in say thirty five days. If the liabilities for the company are due in less than thirty five days, the company may fail to meet its obligations unless alternative funding arrangements are made. The protection of a company’s solvency through proper management of the maturity profiles of assets and liabilities is critical in avoiding corporate failure. In a bank the mismatching of assets and liabilities exposes the bank or financial institution to a further dimension of risk which arise from interest rate fluctuations in the long term.
The risk arising from mismatches in assets and liabilities profiles may be exacerbated by poor lending decisions for example. The idea of lending here includes poor quality credit customers for a trading firm and loans to unreliable customers for a bank. If the customer defaults, the firm which provided credit will also be distressed as its liquidity position is strained. Some companies may report huge profits based on the sale of goods on credit and actually fail to settle their obligations as they fall due. The reason is that the credit sales have not brought in cash to the business for immediate use! Additionally, the firm’s working capital would have effectively been borrowed by the credit customer. If this capital is financed by a loan or an overdraft for example, the firm incurs finance charges which may erode the profit realized on the sale of goods on credit.
One of the common techniques for assessing liquidity risk is stress testing. This is a technique which involves an assessment of the impact of changes in key variables influencing the cash flow position of the company over time. For example, most firms normally prepare cash budgets at the beginning of every financial period. Even our country also prepares a national budget at the beginning of every fiscal year. This is a guide for expenditure and it also highlights cash inflows and as a control tool it promotes a proactive approach to liquidity management. If we expect that the cash flows for a given future period is going to result in negative cash flows, the firm can arrange for an overdraft facility in advance or raise capital in other forms as necessary.
While liquidity risk relating to a firm’s management strategies is critical, it is important to understand that market liquidity may also present challenges to the firm. For example, only a few months ago, there was a liquidity crisis in Zimbabwe. Some companies failed to settle their obligations as their banks failed and some companies could not access cash for payment of wages and so on. This was not the first in the world. In 1997 there was a liquidity crisis in Asia and this experience had its own casualties. The Asian liquidity crisis was mainly related to complications in foreign currency derivatives trading and the foreign currency dimension to our Zimbabwean experience is an interesting area of research.
The liquidity position of a firm involves the assessment of the firm’s working capital management strategies as well as its capital markets. Where a firm faces financial distress the tendency is to usually seek for funding from the bank, suppliers through credit purchases or common stock holders. Therefore, the state of each of these markets is critical in understanding the liquidity position and possible sources of support. Furthermore, it is also important to understand the perceptions of these providers of capital because if the firm is not viewed in good terms, it may not be able to get the desired support. For companies listed on the stock exchange, the declaration of exciting profit figures based on revaluation of fixed assets such as land and buildings certainly require to be supported with additional cash inflows from trading activities. The rational investor will normally prefer to buy shares in companies with reasonable reserves of cash and near cash assets.
This article is published for general investment advice and it must be noted that the price of
equities and the income derived from them can rise as well as fall. Neither First Mutual Limited nor the author shall be held liable for any losses as a result of the investment advice
contained in this article. It is important that specific investment advice is sought as each
investor’s investment will be dependent on their circumstances.
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