Similar to how a banker analyzes a business to determine their ability to pay back a loan, bank regulators analyze banks to determine their ability to pay back their largest lender, their depositors. Bank regulators use what is known as the CAMELS rating system to organize this analysis. CAMELS is an acronym which stands for Capital Adequacy, Asset Quality, Management Quality, Earnings, Liquidity, and Sensitivity to Market Risk. This system is a useful framework to think about the risk of any business.
Last year the banking industry sustained the failures of First Republic Bank, Silicon Valley Bank and Signature Bank which were the second-, third- and fourth-largest bank failures in the history of the United States. When a bank fails their regulator conducts a “Material Loss Review” which is an assessment analyzing significant financial losses, identifying their causes, and recommending improvements to risk management and operational practices to prevent future occurrences. A consistent theme throughout the reviews for these banks is inadequate liquidity risk management, the “L” in the CAMELS rating system.
Liquidity risk is the risk that an entity will be unable to meet its financial obligations when they are due, resulting in loss. This can happen when an entity doesn’t have enough cash or can’t convert assets into cash quickly enough. Effective liquidity risk management has various components including cash flow forecasting, monitoring, a liquidity buffer, and contingency funding plans. These components can be intertwined but, today I want to focus on contingency funding plans. Contingency funding planning is the process of preparing strategies and identifying sources of funding to ensure a business can access cash during unexpected liquidity shortages or crises.
The planning process consists primarily of a business 1) identifying what may cause unexpected stresses on liquidity, 2) mitigating those to the extent you can and 3) identifying and testing sources of contingent funding.
Identification and Mitigation of Potential Liquidity Stresses
The following are examples of unexpected stresses on liquidity and mitigants:
- Delayed or Uncollectable Account Receivable: A major client or concentration of similar clients may not pay you in a timely manner or at all. This can be the result of the economy going into a recession or events specific the client(s). If these receivables are pledged as collateral on a line of credit, this may require a principal paydown on that line of credit. Do you know how delinquent a receivable may be and still be eligible collateral on your line of credit? Are you monitoring the aging of receivables to determine if they are approaching an unacceptable delinquency level? How much time does your line of credit provide for you to make any necessary principal curtailment?
- Supply Chain Disruptions: Companies like homebuilders have faced unexpected liquidity issues due to appliance, electronic components and other material shortages, halting production and delaying revenue generation. What obligations do you have as a purchaser or seller under your contracts for supply chain disruptions? Can you access cash or do your contracts allow for additional time to cover the additional carrying cost of the extended cash conversion cycle?
- Unexpected Expenses: Unforeseen costs, such as equipment repairs, legal fees, or emergency maintenance, can arise unexpectedly and disrupt cash flow.
- Unplanned Growth: If your business expands unexpectedly, it may need to invest in additional inventory, equipment, hire more staff, all of which may require upfront cash.
- Balloon Loan Payments: Business owners generally expect to pay their ballooning loan with a new loan however, this is not always feasible. Decreasing collateral values and increasing interest rates causing higher debt payments coupled with more aggressive leverage on the original loan are typical culprits of creating problems with refinancing ballooning loans. This issue is particularly prevalent now and “cash-in” refinances, where a lump sum principal payment is needed to refinance an existing loan, are common. Will you need to come up with cash for a “cash-in” refinance? Are you saving cash for this purpose? Will you sell an asset or obtain a “cash-out” refinance on another asset to come up with this cash? Will you explore higher leverage financing alternatives such as Small Business Administration (SBA) to minimize the cash needed?
- Demand Loan Facilities: Do you have loans where the lender can require you to repay the entire loan balance at any time? How much, if any, time does your loan agreement give you to make such a payment? If your lender cannot require you to repay the entire loan balance at any time, can they shut off future availability on your line of credit?
- Natural Disasters, Pandemics and Other Disasters: Floods, fires, pandemics and disasters like the collapse of the Key Bridge may bring operations to a halt and require cash to get things up and running. Do you have insurance coverage for these items? Does any such insurance have business income coverage? How long will it take to obtain cash from your insurance company and can your bridge this difference?
- Market Changes. The term “Market Changes” can incapsulate everything from products that are dependent on a strong economy such as recreational vehicle sales to industries that are impacted by technological changes such as retail with the growth of e-commerce. Other items to consider are rapid changes in consumer preferences or competition. In a 1995 interview with Charlie Rose, Bill Gates explained why he kept so much cash on hand for Microsoft, saying, “Things change so fast in technology that the next year’s business wasn’t guaranteed….” Gates insisted on keeping enough cash in the bank to keep the company alive for 12 months without revenue. If the market change is more cyclical in nature, that should be handled through your liquidity buffer however, if they market change is less predictable this
- Regulatory Compliance Costs: New regulations or changes in compliance requirements can impose significant costs on businesses, including fees for licenses, permits, and compliance training, which may require businesses to allocate more cash to meet these obligations.
Sources of Contingent Funding
The next question you want to answer is, “Where can I get additional cash if I am managing through one of this liquidity stress events?” The following is a list of some contingent funding sources used by businesses. It is important to note that certain sources are not appropriate or practical for certain liquidity stress events:
- Liquidity Buffer: The simplest source of contingent funding is keeping savings above and beyond what you need for normal operations.
- Availability on Lines of Credit: Do you earmark a portion of your line of credit or have a separate line of credit used solely for liquidity stress events? Do you maintain lines of credit with multiple lending institutions in case one lender demands repayment if the entire loan balance or shuts off your availability? Do you have a Home Equity Line of Credit in place as contingent funding sources to contribute capital to your business?
- Sale of Assets or Cash-Out Financing of Assets: The sale of an asset, such as real estate, can generate significant cash however, is a lengthy process. If you have significant equity in assets consider establishing a line of credit secured by those assets before you need liquidity. If you see a liquidity stress event such as a “cash-in” refinance coming down the line, prepare early
- Emergency Loan Programs: The Small Business Administration, other government agencies and non-profits have loan programs to support business during disaster and other types of emergencies. Businesses owners that went through the Payroll Protection Program, know how important it can be to have an existing relationship with you banker when trying to navigate one of these programs.
- Private Lending and Equity
- Other potential contingency funding sources not specially discussed include Trade Credit, Factoring Agreements and Merchant Cash Advances.
Your banker should be trained to find potential risk and identify mitigants to those risk. Don’t hesitate to reach out to your banker to get their perspective on your business’s liquidity risk.
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