Managing Corporate Liquidity

Lance Moir

• Publisher: Routledge
• Year: 2014
• ISBN:
  9781135951931
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

Cash, as every manager knows, is the life-blood of a business. Managing cash flow, interest rates, and banking relations are some of the most important functions of treasury management. Managing Corporate Liquidity is a practical and concise guide designed specifically to offer advice and insight into the fundamental decisions of liquidity management. This book also takes into account the increased use of liquidity instruments, looking in detail at interest-rate hedging and the various control mechanisms that have been developed in recent years. An essential guide for treasury managers, financial managers at all levels, and entrepreneurs, business owners, and their advisers.

1

What is liquidity and how does it arise?

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● The definition of liquidity

● The broad objectives of liquidity management

● How liquidity impacts on a business

What is liquidity?

The liquidity of an organisation is the ability to make payments as they fall due. Perhaps more important are the consequences of illiquidity which are likely to lead to a business ceasing to trade.

A company may be highly profitable in an accounting sense, but this is of no use if there is no cash to pay employees and suppliers and no cash to make further investments. Conversely, a company which is making large accounting losses may be generating substantial cash (e.g. early in the 1980s Courtaulds made substantial accounting losses, yet generated millions of pounds before repaying loans and paying dividends). This may be the result of writing off assets or by creating accounting provisions as well as high levels of depreciation.

Although the availability of liquidity to a company is the prime objective, that liquidity also requires active management in order to benefit the company in a financial sense, but also to avoid and minimise risk.

The scope of liquidity management usually extends to the management and control of:

● cash flow and cash flow forecasting;

● investments and borrowings of up to 1 year;

● availability of borrowing facilities;

● short term interest rate management.

It will also cover detailed applications including money transmission, and debtor and creditor management.

How does liquidity arise?

In order to manage effectively a company’s liquidity, it is important to understand how it arises and the uses that it is put to. In particular, there is a need to understand the dynamics of the business, particularly in so far as these affect the cash flow. For example, as sales grow, a business must assess how much extra cash is consumed by working capital (or, less commonly, for some businesses such as large food retailers, how much cash is generated).

As part of the normal business cycle, liquidity arises:

1 By generating profits in cash terms; that is, through selling goods for cash in excess of that required to produce them. This will be made up of a number of cash flows, both in and out:

(a) cash sales;

(b) receipts from debtors;

(c) payments to creditors;

(d) operating costs;

(e) capital invested;

(f) dividend and interest payments.

Naturally it follows that if the business is either growing or inefficient, then liquidity is consumed rather than generated. Inefficiency also includes increasing stock levels greater than needed to meet sales. Stock positions, however, arise as a combination of the purchase of raw materials and slow cash sales rather than as cash movement in themselves.

2 By selling for cash assets that are no longer necessary.

3 By raising funds (either debt or equity) in excess of the amount needed for investment by the company at that time. This might typically happen where a company has a planned expansion programme and decides that it would be prudent to raise the necessary finance in advance (e.g. pharmaceutical development or oil exploration).

Liquidity is consumed:

1 By making new investments in fixed assets, or acquiring businesses.

2 By increasing working capital in order to expand sales or improve margins.

3 By making losses in excess of the depreciation (and other noncash) charge.

These are the factors that affect liquidity over a long term business cycle, but on a day-to-day basis, more significant factors are likely to be receipts and major payments to suppliers or for payroll. For many small businesses, it is items such as these that really represent liquidity.

It is important to note the emphasis on cash in the above lists. The amount of cash available can be measured unambiguously, whereas other accounting treatments can be more subjective. The amount of cash used in working capital is particularly important and in situations of illiquidity it is often working capital that can be squeezed first to generate liquidity, where other assets will take longer to realise.

For many businesses, the emphasis in liquidity management is associated with working capital management – that is, ensuring that payments from debtors are received swiftly, stocks minimised and payments to creditors delayed until the latest commercially sensible date. However, the key feature of liquidity management is the availability of liquidity, therefore for businesses which are not trading at their limit, this is often the borrowing facilities available, typically overdrafts for small businesses (but also committed borrowing facilities for larger companies) or investments that are liquid, such as bank certificates of deposit or quoted securities.

How does liquidity management fit into
treasury policy?

Every business should have a clear set of treasury policies that establish the board’s attitude towards the various treasury activities, such as the level of risk to be adopted, the level of gearing (and therefore the amount of debt to be raised) and who is authorised to deal on the company’s behalf. Within these policies, there should be sections setting out the policy towards liquidity management, in particular covering:

● cash management;

● short term investment management;

● short term interest rate management;

● money transmission management.

These policies cannot stand independent of the total treasury activity – for example, short term interest rate management should fit with the overall risk profile. Money transmission will depend upon the group’s attitude to centralisation – do all international payments net through a centre or are they managed locally?

The objectives of cash management policy

The policy on cash management for a large group should comprise at least the following:

1 A brief description of the origins of short term cash and funding positions around the company.

2 The objectives of the policy, for example to provide adequate and cost effective banking services for the company and its subsidiaries by:

(a) minimising the level of funds in subsidiaries while ensuring the provision of short term financing for day-to-day working capital requirements;

(b) maximising the income from short term surpluses held in bank accounts, and minimising the cost of short term deficits, through active management of bank account balances;

(c) ensuring that, where possible, the most efficient and cost effective banking practices are observed.

3 A standard for the bank account configurations across the company. This should define the optimum number of banks to be used and the cash management facilities that should be provided, interfacing with group-wide systems where appropriate, including netting and pooling (see Chapter 4).

4 The standards for local treasury dealing facilities, where required, including overdrafts, deposits and foreign exchange dealing lines, including a company-wide standard bank mandate.

5 Policy on the use of parent company guarantees, letters of comfort and other support agreements.

6 Where not specified elsewhere, a list of authorised counterparties, with associated at-risk limits. These will link into the bank relationship management policy.

7 Where not specified elsewhere, a reference table of authority limits for opening bank accounts and establishing local banking relationships.

What are the objectives of short term
investment management?

The sheer importance of continuing liquidity to a business has led to a very strong trend towards centralisation of cash and general treasury management within groups. The small business always has to concentrate on cash flow, and this is also true in the largest multinational group. Other policies are discussed later in the book. However, it is appropriate to set out the objectives of short term investment management here as the philosophy is important to understand up-front.

The prime objectives of short term investment management are:

1 Liquidity. The business must be able to meet its liabilities as they fall due.

2 Safety. Investments should not be exposed to the risk of an unacceptable loss in capital value, and borrowing facilities should continue to be available when needed (i.e. there is no point in having borrowing facilities available if the prospective lender is about to fail).

3 Profitability. Only once it is certain that the first two objectives can be met, can the question of re...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright Page
• Table of Contents
• Preface
• 1 What is liquidity and how does it arise?
• 2 Forecasting liquidity
• 3 The management of uncertainty
• 4 Money transmission and bank services
• 5 The structure of interest rates and the yield curve
• 6 Liquidity and the use of deposit and borrowing instruments
• 7 Interest rate risk: definition and management
• 8 Instruments for interest rate management
• 9 Liquidity management in practice
• 10 Organising liquidity management
• Glossary
• Appendix: Useful calculations
• Further reading
• Index