If cash is king in business, ensuring that you have access to it is just as important


Introduction: Liquidity Is Your Best Hedge Against Risk


As a small business owner, you have a handle on the cash flow required to keep your business operating under normal circumstances. But how accurately have you assessed your ability to liquefy assets quickly in response to unforeseen circumstances?


To get a reliable answer to that question, you need to master an accounting balancing act, says Paul Stahlin, CPA, CGMA, and former chair of the board of directors of the American Institute of Certified Public Accountants (AICPA). In one column is “how much liquidity you need to have on your balance sheet.” In the other, how much you have in “assets that are close to liquid, and how quickly you can get them.” Together, these elements constitute “a stress test that happens whenever you have a natural or unnatural disaster.”


Small businesses are being subjected to that stress test more often in an increasingly global economy, he says. The March 2011 tsunami in Japan sent shock waves through the supply chains of some markets and industries in the U.S. More recently, tens of thousands of small business owners in the greater New York metropolitan area found their companies brought to a standstill for weeks following Hurricane Sandy.


That “superstorm” also demonstrated the limitations of crisis planning. Companies in areas left largely untouched by the storm had to remain closed for days when employees had no way to get to work. Small business owners who had invested in generators to see them through extended power outages found themselves unable to get the gasoline necessary to keep those generators humming. “You can’t calculate the risks precisely of what’s going to happen into the future,” Stahlin says. “And that’s why you need to have some liquidity in your balance sheet. I’m all about risk management, and risk management does play into liquidity needs.”


Create a Liquidity Plan


“Think forward,” says Craig E. Aronoff, chairman and principal of The Family Business Consulting Group and co-author of Financing Transitions: Managing Capital and Liquidity in the Family Business. “To plan for liquidity means you have to plan, and the first element of business planning is having a budget. If you have a budget, then you can make a better projection relative to your cash flow and your cash flow needs. And if you can do that, then you can do a better job of managing your cash flow, which is a liquidity issue.”


Next, he says, small business owners must probe longer term questions. “Do we want our business to grow? Is it growing? What do we need to make it grow? What kinds of investments do we need to make to support our growth? That’s called capital budgeting, and it’s a process of planning out: here’s our goals, here’s what we want to do, here’s what it’s going to take in terms of money. What other resources are required, and how do we work this out? It’s a thoughtful approach to thinking out the future. That can be translated into a capital budget that says, “In six months, we’re going to need X dollars. And in twelve months, we’re going to need Y dollars. Or here’s the list of things we need money for, and then we need to go backward and plan for that.”


Those projections can relate to anticipated business or personal needs, experts say. They can involve anything from heightened disaster preparation to planning for market or product line expansion, construction of new facilities, or growth in payroll. But they can also spring from, for example, the knowledge that a senior partner plans to retire in ten years and will have to be bought out at roughly the same time that the remaining partners want to take some distributions as their children enter college.


Inheritance and estate taxes introduce further potential tests of liquidity. “Transferring ownership of the family business to a new generation is often more complicated than it sounds,” the U.S. Small Business Administration (SBA) warns. “Additional tax implications, such as estate and gift taxes, generally arise for both parties. Proactive succession planning can help provide business stability, prepare for tax obligations, and make the ownership transfer as smooth as possible.”


Any of these issues can put challenges to liquidity on the company’s horizons. Even with months or years of advance warning, business owners can be blindsided by those challenges if they don’t have an accurate grasp of the value of assets they can liquefy and the time it will take to convert them to cash.


Capital Calculations

“Cash is king. Capital is queen. That’s what people have to look at, and small businesses often underestimate. They’re trying to do something on the margin. They’re trying to make the best they can out of what little they have,” Stahlin says. “That’s not a criticism of them, because that’s why they’re in business. They’ve got the entrepreneurial spirit. If it was easy, everybody would do it. But that is why businesses fail often, because there’s just not enough capital, there’s not enough liquidity, and there’s not enough ability to repay if there’s a little blip.”


What are some of the most common mistakes that small business owners make in assessing their liquidity? Do they over-invest in inventory? Overestimate the value of the assets they have on hand? Underestimate the time it will take to convert those assets to cash?


“They’re doing all of those,” Stahlin says. “They’re underestimating the time it takes to make things liquid. They’re underestimating how much they need. I can look at a small business’s checking account, and I can see the velocity of what goes in and what goes out, and the average balance, and you can tell that they don’t necessarily need a loan; they need another source of revenue.”


Aronoff underscores that point. “When small businesses get into a liquidity crunch, it’s because they’re doing something else wrong, not because they haven’t watched their cash draining out of their checking account.” One example is a source of increased liquidity that some business owners overlook: their accounts receivable. “If you have a liquidity problem, and you need to be told that you need to be more aggressive in collecting your accounts receivable, then you’ve got a different problem, which is that you’re not collecting your accounts receivable,” he says. “But that is another source of liquidity, and of course it can be used for factoring and other ways of generating cash.”


Avoiding Collateral Damage


Rejected credit applications can serve as a wake-up call for small business owners who make some of these mistakes, Stahlin says. “Particularly when they’re real estate rich, they say, ‘I’ve got plenty of collateral. How could you be classifying my loan as substandard if I’ve got all this collateral?’ Well, collateral, unfortunately, in a quick sale, diminishes very quickly.” That’s especially true in the current environment when business owners are overconfident in their ability to convert real estate assets to cash. “People think, ‘I’ve got this piece of property; I could sell this in three months.’ Well, that’s not the case anymore. So they overvalue that collateral on the basis of the time that they have to disburse it, or liquefy it.”


An excess of caution can be equally harmful to the company’s health. “It can stifle growth,” Stahlin warns. “If you’re too conservative, you’re not reinvesting in the business. There’s got to be a formula that you develop within your business on how much you put back into the business. You can’t be shortsighted. One of the biggest issues if people are too conservative is that they’re not thinking out three to five years into the future on the vision for growth. Sometimes that will constrain growth in operations.”


Increasing Liquidity, Reducing Risk


Best practice for ensuring an accurate read on liquidity before there’s a need to tap the assets, calls for input from at least three parties. “You need the business owner, the banker—who you have to have a relationship with; it’s all based on relationships—and somebody with financial acumen. That’s usually where the CPA comes in,” he says. It’s usually advisable to include the company’s legal counsel in the discussions, too. 


The process is not a one-time exercise but one that requires attention at least monthly. “It depends on how fluid your business is and how much tie to high turnover there is. There’s a definite correlation to the velocity of money going in and out of the business. The correlation should be, the higher the velocity, the more often you should be looking at the liquidity balance,” Stahlin says. “Business owners have to balance out running the business and the back office operations. I ask them, ‘What is the most critical point to you in your business?’ To be a good businessman, you can’t just run your business. You’ve got to own a piece of that banking expertise, a piece of that CPA expertise, and the legal expertise, and it’s all got to be wrapped around, because that’s how you develop your risk tolerance.”


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