Liquidity: A complex business game!

The liquidity of a company depends on how management decides to match up its sources of cash with uses, today and in the future. Cash on hand is one of the components to consider when determining if ‘liquidity-sources’ match ‘liquidity-uses’. Other components of liquidity include:

The frequency and amounts by which cash balances are replaced [from an operating source (operating cash flow) and/or by accessing the capital markets (financial cash flows)];

Why these liabilities were incurred (to achieve profits?);

How they will be paid (from operations and/or more borrowings?);

When they will be paid (time);

What must be sacrificed to do so (priorities)?

All the above determine if the market considers a company to be cash rich or cash poor.
 
What levels of liquidity are required to be considered cash rich or poor? Some profitability, liquidity and risk metrics which can be used to answer the question, are the following:

Positive EBITDA: Earnings before interest, tax, depreciation and amortization (EBITDA) are a measure of future operating cash flows. Note that it doesn’t take into account loan-interest expense, foreign exchange gains or losses and taxes which are considered as important for a company’s operations.

Positive free cash flow: If EBITDA flows are enough, then they can pay for capital expenditure, dividends etc. With positive free cash flow (i.e. positive operating cash flow less ‘capex’ and dividends) a company can think about other best uses, i.e. paying down debt. A company that cannot produce enough operating cash flow to re invest in its’ future will disappoint its shareholders (no dividends) and its bankers (difficulties in repaying debt when it comes due).

Cash on hand: With the right levels of cash on hand (and in the right currencies), management is in a stronger negotiating position with creditors.  How much cash to maintain on hand can depend on the length of a company’s operating cycle and the duration of its liabilities.

Ability to borrow: Having access to more cash is almost as good as having it on hand.

Length of cash conversion cycle: Companies that quickly purchase, process and then convert sales to cash, can operate with less cash-on-hand because they are able to replace that cash faster.

Funding cost: Funding should be supplied at the lowest all-in cost over the time of fiscal period. The costs of funds should include also the cost to ‘operate’ those funds by areas like treasury, which are responsible for allocating funds to business units based on best uses.

There is no right answer about how much liquidity is enough except to say that more liquidity allows a company to protect itself from market forces that could jeopardize its market value.


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