Liquidity Crisis and Cash Flow Management
Liquidity Crisis and Cash Flow Management
Cash Flow Management
Cash flow management focuses on studying and controlling the inflows and outflows of cash within the organization to achieve three main objectives:
- Operational Continuity:
Ensuring that the company maintains a minimum level of cash to purchase raw materials and settle obligations with suppliers, thereby enabling ongoing operations. - Security and Risk Avoidance:
Avoiding financial difficulties and risks associated with insolvency and late payment penalties. - Competitive Advantage:
Maintaining a certain level of liquidity to capitalize on market fluctuations, seize short-term opportunities, and mitigate unforeseen risks, thus supporting short-term competitiveness.
Cash Flow Strategies for Payments and Collections
In business, employing cash flow strategies is not unethical; rather, it aims to retain cash within the company’s treasury as long as possible before payments are due to creditors, without resorting to delinquencies. Similarly, it seeks to accelerate collections from debtors without becoming overly rigid or unjust. An experienced financial manager recognizes the importance of these strategies to enhance the company’s financial position, including:
- Delaying Payments:
By postponing payments to creditors, a company can accelerate its cash cycle, shorten the payment period, and increase its cash turnover rate. For instance, if the company pays suppliers every 40 days, there would be nine payments annually; extending this period to 50 days reduces the number of payments to seven per year.
Since cash conversion cycle = production and sales period + collection period – payment period, increasing the payment delay from 40 to 50 days shortens the cycle.
The cash turnover rate is calculated as 360 days divided by the cash cycle duration; thus, extending the cycle from 80 to 90 days increases the turnover from approximately 4.5 times to about 4.8 times annually. - Accelerating Receivables Collection:
Financial managers can effectively reduce the average collection period from 40 to 30 days by improving debt collection procedures. This accelerates the cash cycle and increases cash inflows. Notably, combining delaying payables with faster collections yields better results than employing either strategy alone. - Sources of Liquidity:
Companies have three primary sources of cash: - Revenues from sales and advance payments
- External financing, such as loans or aid from banks and institutions
- Issuance of new shares
Despite access to credit, many commercial transactions rely on short-term trade credit. Companies often purchase on deferred payment terms when immediate cash is unavailable. This allows many firms to achieve high profit margins even without sufficient current assets or cash liquidity. Does this mean cash management is unnecessary if payments can be postponed and credit used?
Actually, the opposite is true: utilizing credit requires more precise cash flow forecasting than companies relying solely on internal funds.
Cash Is More Important Than Profits
Companies settle obligations not based on profits but on cash flow or deferred payments. While profit is a key objective, creditors, employees, and lenders primarily require cash. Failure to provide sufficient cash incurs higher costs and restrictive conditions. Therefore, it’s crucial to prioritize cash flow over profit. Maximizing cash inflows and balancing them against outflows ensures greater financial stability and success—though this perspective is relevant mainly in the short term.
Break-Even Point in Cash
This is the sales volume at which cash expenses equal cash revenues within a specific period. The financial manager analyzes the cash break-even point to determine the sales level needed to cover all cash expenses payable to external parties. It’s most useful for short-term planning (up to one year), as it doesn’t typically account for expenses like R&D, which may take years to impact sales.
Exercise:
Using the following hypothetical balance sheet, assess the company’s liquidity position and suggest steps management should consider:
| Assets | Liabilities |
| Cash: 200 | Accounts Payable: 600 |
| Accounts Receivable: 100 | Notes Payable & B/P: 500 |
| Inventory: 400 | Outstanding Expenses: 100 |
| Total Current Assets: 700 | Total Current Liabilities: 1200 |
| Fixed Assets: 1000 | Shareholders’ Equity: 500 |
| Total Assets: 1700 | Total Liabilities & Equity: 1700 |
It’s evident that net working capital is negative:
Net Working Capital = Current Assets – Inventory – Current Liabilities = 700 – 400 – 1200 = -900
This indicates the company has financed its fixed assets and inventory (totaling 1400) through current liabilities exceeding its current assets (liabilities are 1200, assets are 700). The current ratio:
Current Ratio = Current Assets / Current Liabilities = 700 / 1200 ≈ 0.58
This means the company cannot cover