Why do firms feel that liquidity is desirable even though it may mean that the firm does not utilize the investment capability of cash?
CASH IS KING! This was highlighted in the article and has become the popular slogan at the peak of the 2008 financial crisis. Indeed, this phenomenon is more apparent in bad times than in good times when businesses and households are somewhat oblivious of their accumulating debt and complacent which entail potential liquidity risks. If for anything, a financial meltdown reminds everyone again of the importance of being liquid.
So why is liquidity important? In Keynes liquidity preference theory of interest, he notes that “interest is the reward for parting with liquid control over cash for a specific period”. He further provided three main reasons why firms and households would carry cash instead of earn interest out of it. They are mainly for transaction, precautionary and speculative motives (EconomicsExposed.com, nd).
In simple terms, having enough cash secures the payment coverage of day-to-day expenses, such as supplies, rent, utilities, and salaries of employees (i.e., transaction motive). However, having extra cash is deemed a better position because it serves as a buffer to cover unexpected expenses or business events that might result to being cash strapped or in extreme cases, bankruptcy (i.e., precautionary motive). For instance, in difficult times, a major client could default in payment. This may jeopardize a firm’s main source of revenues and lead to shortage of cash available for planned projects or unexpected and extraordinary expenses. Imagine if these incidents were to continue for a period of time, eventually, this would compel some firms to acquire debt to finance their operational requirements. As debts entail interest costs, they add credit risks to any business operation.
On the other hand, for financial institutions or individuals cognizant of market opportunities, their motive of keeping cash could be partly speculative i.e., to capture interest earnings or potential returns on investment opportunities.
(b)What other means does a firm use to take advantage of investment opportunities since cash must be kept on hand?
Despite the need to maintain cash, businesses are still able to take advantage of investment opportunities by putting their extra cash in money market, stocks and bonds. This type of investments is short-term and can be liquidated immediately. Thus, firms holding these investment instruments still have the security of availability of funds when needed.
Another method that firms employ given their limited funds is on capital investment allocation. When analyzing options on proposed uses of available funds, expenses are budgeted while projects are prioritized based on certain criteria. Usually, this is based on highest net present value or expected returns. But in times when cash is tighter, payback criterion is considered highly. This enables the company to decide on projects that recovers capital investments the soonest possible time.
- Explain how a firm should address the area of credit controls
In the light of the 2008 financial downturn, the Basel Committee on Banking Supervision re-emphasized the importance of having sound credit control mechanism for banks and financial institutions (Bank of International Settlements, Sep 2008). This is to reinforce the system in place to prevent irresponsible granting of loans which brought down the economy when debtors were no longer able to pay for their loans, mainly their huge mortgages.
For other types of business, the control measure is more applicable on how they extend credit to their clients to ensure on-time payments. The timely collection of payments from clients is crucial since it is the major source of revenues and therefore, the cash required to meet operating expenses. The timing of receipt of payment from sales and payment of expenses including those for suppliers, determines the steady flow of production or services. Thus, credit controls have to be in place from approval of credit up to collection.
Among the ways to control credit are:
- Establishment of credit policies and procedures that will serve as guiding principles for extending credit.
- Installation of a system, that eliminates subjectivity or human error in extending credit, aids in controlling credit risk. Automating sales and distribution help facilitate accurate payment collection through credit. It also helps build database that enables managers make effective and efficient future business decision.
- Ensure sound criteria in approving a client’s credit application. In essence, a customer or client must be assessed carefully of his capability to pay on time.
- Setting a credit limit is likewise important. When the financial crisis happened, many banks performed stress test on credit applications to determine how much credit a client can pay even in a tighter scenario (i.e., higher interest rate).
- As needed, collateral or form of insurance may be demanded to provide an added security in case there is a potential risk in payment collection.
- Managers and front-liners must be trained on set credit policies and its strict implementation.
- Identify and explain tell-tale signs of a company in trouble with liquidity
As in the case of the companies cited in the article, the immediate sign of a company having liquidity problems is its failure to pay its short-term obligations, such as rent or employee salaries. These are essential to operation that a firm must never miss. The more obvious one is when a company has already filed for bankruptcy.
But even before a firm reaches the bankruptcy stage, there are other tell-tale signs namely:
- Employing drastic cost-cutting measures such as laying off people or reducing working capital to save on cash.
- Requesting customers to pay on cash rather than credit. This reduces the waiting period to convert sales to cash, as well as prevent risk of non-payment.
- Applying for increase credit limit or another credit line to fund operations or special projects.
- Selling some assets to generate cash.
Basel Committee on Banking Supervision (Sep 2008). “Principles for Sound Liquidity Risk
Management and Supervision”. Bank of International Settlements. Retrieved from http://www.bis.org/publ/bcbs144.pdf
Dublin City Enterprise Board (nd). “Best Practice Tips for more Effective Credit Control”.
Retrieved from http://www.dceb.ie/Knowledge-Centre/Finance_Taxation/Tips-for-Effective-Credit-Control
ECCU Investing in Ministry (2014). “Liquidity Management, Part One: Why Is It
Important?” Evangelical Christian Credit Union. Retrieved from https://www.eccu.org/resources/articles/2007/october/iss05-01
Economics Exposed (nd). “Keynes’s Liquidity Preference Theory of interest”. Retrieved
Kremers, K. Navigating a Liquidity Crisis Effectively. Bloomsbury Information Ltd, 2009–
13. Retrieved from http://www.qfinance.com/cash-flow-management-best-practice/navigating-a-liquidity-crisis-effectively?page=1