Cash & Liquidity Management

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Liquidity Management in Turbulent Times The current market compels management and directors to take a fresh look at liquidity risk management practices - in particular continued access to credit markets, key cash flow assumptions, what-if analysis, and contingency planning.

Liquidity Management in Turbulent Times

by Jim Negus, Partner, US Bank Finance, Treasury and Capital Markets Practice, KPMG

Given today’s turbulent global economy, external directors increasingly ask executives to demonstrate the company’s ability to remain viable and liquid. The renewed ‘call to action’ is largely driven by a strong deterioration in global markets fuelling significant funding cost increases and unprecedented investment and capital losses.

While leading companies have successfully managed liquidity in prosperous times, the current market compels management and directors to take a fresh look at liquidity risk management practices – in particular continued access to credit markets, key cash flow assumptions, what-if analysis, and contingency planning.

Liquidity management defined

Liquidity management is a concept broadly describing a company’s ability to meet financial obligations through cash flow1, funding activities, and capital management. Liquidity management can be challenging as it is impacted by revenue and cost generating activities, capital and dividend plans, and tax strategies. Additionally, it is closely linked to broader market, credit and general business risks.

Board focus

Given the sheer volume and magnitude of organisational failures experienced in 2008 and 2009, liquidity management has become a frequent agenda item at leading board and Audit Committee meetings. While each company is unique, board requests have typically focused on renewed liquidity transparency and governance. In addition the amendments to the Companies Act require the board to consider these aspects.

Liquidity transparency

Despite a significant increase in corporate risk management capabilities over the last decade, directors have had less exposure to liquidity risks when compared to other prominent exposure categories (e.g., market, credit, compliance, regulatory, etc.). While this was partly due to a history of economic prosperity, directors now expect more frequent liquidity updates and greater visibility into key cash and liquidity measures.

For example, many boards now require management to provide quarterly or more frequent liquidity updates, often with rolling base case cash forecasts and stress scenarios covering depressed market and operational conditions and credit facilities. Leading companies typically establish formal liquidity thresholds, contingency plans and internal accountabilities – all of which assist management and directors to gain visibility and evaluate liquidity risk. Each topic is described in greater detail below:

  • Base case cash flow forecast using standardised assumptions: The base case forecast represents significant or ‘best estimate’ cash in-and out-flows. The base case forecast is most effective when driven by common enterprise-wide assumptions, to the extent feasible, and key assumption support. For instance, organisations may provide revenue and expense forecast assumption guidance including geographic unemployment estimates, short- and long-term interest rates, foreign currency rates, counterparty default rates, product margin, and payment terms, to name a few. While this process may be challenging for international and highly decentralised organisations, there is anecdotal evidence suggesting value achieved through improved cash flow aggregation and awareness.
  • Scenario and stress tests: Directors increasingly request management to shock and report base case scenarios under various ‘downside’ conditions. These ‘stress test’2 results, as they are typically referred to, reflect cash flows and credit facility availability under distressed revenue and expense environments. Stress tests generally involve a ‘worst case’2 and other management or regulatory-defined scenarios. Stress tests3 allow management and directors to assess the degree to which core forecasts and assumptions may be negatively affected by prescribed events, the impact to an organisation’s ability to satisfy certain obligations, and the degree to which an organisation is exposed.
  • 12-Month rolling base case and stress forecasts: In many organisations liquidity risk has been viewed on a short-term basis, largely supporting working capital and short- to medium-term financing needs. This trend has shifted as boards have extended liquidity and cash forecast requirements to address at least a one-year time horizon, generally reported on a rolling monthly basis. The benefits achieved through a longer liquidity window include greater transparency into significant cash outflows (e.g., debt maturities, M&A, etc.) and improved lead time to employ traditional or creative measures to satisfy such obligations.
  • Liquidity threshold: While base case and stress scenarios increase board awareness, results may lack context required to drive desired action. As a solution, organisations have turned to liquidity thresholds and supporting contingency plans. The liquidity threshold typically represents a formal tolerance level (or band) ‘triggering’ management oversight or remediation. Example liquidity thresholds include maximum credit facilities, downgrade risk4 (e.g., debt/EBITDA), capital structure ratios (e.g., debt to equity), short- to long- term debt financing ratios (e.g., <25% short-term financing), and various debt covenant thresholds relevant to cash, credit or capital markets (e.g., interest coverage).
  • Liquidity contingency plans: Once the liquidity thresholds are established, management assigns permitted or required actions (herein referred to as the liquidity contingency plan) to each tolerance level or band. The liquidity contingency plan typically guides management through various liquidity scenarios ranging from minimum cash and liquidity balances, permitted funding sources and mix, equity repurchase and capital expenditure permissions to available working capital and operating cost reduction strategies. In addition to serving as a management guide, the contingency plan can assist directors to quickly ascertain critical liquidity risk thresholds and desired outcomes under normal and extraordinary times.

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