In one classic finance case I took up in graduate school, an owner-manager of a small business was very pleased reviewing the positive results in the firm’s profitability metrics – net profit margin, gross profit margin, return on assets and return on equity. Noting the favorable results, the entrepreneur decided to go on his regular Lenten vacation break. While on travel, he received reports from back home that the company was in dire straits. The problem concerned a low cash position and inability to meet financial obligations becoming due. In short, the firm faced a liquidity crunch.
Despite the firm’s profitable position, which is an indicator of possible long term success, it needs to generate enough cash flows from operations to finance their short term operational needs. A business can be profitable without being liquid. Long term success requires good working capital management. The task is to find a fine balance between meeting long term profitable goals and having enough cash to meet short term needs.
Small businesses by nature have limited resource pools. In the ups and downs of the business cycle, they are vulnerable to the ill effects of market fluctuations and unforeseen events. Poor working capital management such as inefficient accounts receivable or accounts payable processes can exacerbate their situation.
Following are some examples of the diverse range of liquidity concerns. One, customers can delay payments or default on their obligations. Small businesses often allow customers to pay for goods and services at a later date. This can strain the cash flow and lead to liquidity problems. Two, maintaining excessive levels of inventory ties up capital that could be used for other business purposes. If inventory turnover is slow, or if products become obsolete or perishable, it can lead to a low cash position.
Three, unexpected expenses, such as equipment breakdowns, emergency repairs, or legal disputes, can strain a small business's finances. Four, seasonal businesses, such as those in the tourism, agriculture, or retail sectors, often experience fluctuations in cash flow throughout the year. During slow seasons, these businesses may struggle to cover operating expenses and maintain liquidity.
Five, while debt financing can provide small businesses with much-needed capital to fuel growth, excessive reliance on debt can lead to liquidity problems, especially if debt service obligations become unsustainable, resulting in high interest payments and dwindling cash. Six, small businesses operating in volatile or highly competitive markets may face liquidity problems due to unpredictable shifts in demand, pricing pressures, or changes in consumer preferences.
However, with the right approach and strategic planning, small businesses can weather these storms and emerge stronger than before. The cornerstone of any successful liquidity crisis management plan is meticulous cash flow management. Small businesses should closely monitor their cash inflows and outflows, identifying any potential gaps or discrepancies. By maintaining accurate cash flow projections and implementing measures to optimize cash inflows, such as providing discounts for early payments from customers or renegotiating payment terms with suppliers, businesses can proactively address its own fund needs.
During a liquidity crisis, every centavo counts. Small businesses should scrutinize their expenses and identify areas where costs can be reduced without compromising essential operations. This may involve renegotiating contracts with vendors, consolidating services, or implementing austerity measures. By prioritizing essential expenses and cutting back on non-essential spending, businesses can preserve cash and improve their financial resilience.
Debt can exacerbate liquidity challenges. Effective debt management is crucial during times of financial strain. Businesses should assess their existing debt obligations and explore options for refinancing or restructuring loans to improve cash flow. Negotiating with creditors for extended payment terms or temporary relief can provide cash flow breathing room.
Excess inventory ties up valuable capital that could be used to address financial obligations. Small businesses should review their inventory levels and implement strategies to optimize stock levels. Relying too heavily on a single revenue stream can leave small businesses vulnerable to liquidity crises. Diversifying revenue streams can help mitigate risk and provide alternative sources of income during challenging times.
Small businesses must develop a contingency plan for unforeseen liquidity crises. This may involve establishing an emergency fund or securing access to alternative sources of funding, such as lines of credit or standby loans. By preparing for potential financial challenges, the firm can minimize the impact of liquidity crises and maintain stability. .
Managing liquidity risk can also provide opportunities for growth and development. A proactive approach to liquidity management includes maintaining liquidity buffers, diversifying fund sources, continuous monitoring and adapting a culture of preparedness. Small businesses that navigate through liquidity crises with confidence will emerge stronger on the other side. With resilience, resourcefulness, and strategic planning, small businesses can thrive in the face of adversity.
(Benel Dela Paz Lagua was previously EVP and Chief Development Officer at the Development Bank of the Philippines. He is an active FINEX member and an advocate of risk-based lending for SMEs. Today, he is independent director in progressive banks and in some NGOs. The views expressed herein are his own and does not necessarily reflect the opinion of his office as well as FINEX.)