Liquidity Risks for Small Business: how you can Prepare for a Squeeze

Global liquidity seems to be drying up. The Federal Reserve’s policy of increasing interest rates, which it has been doing incrementally since 2015 – has a big part to play in this. They now stand above 2%, whereas prior to this – since 2009 – they’ve been near zero. Banks throughout the world are following suit: even the Bank of England is raising rates, which are now sitting at their highest level since 2009. In China, slowing economic growth has been accompanied by increasingly parsimonious lending and the drying up of state-backed credit facilities. According to the economist Merril Lynch (Bank of America) we’re globally not far from being back to pre-Lehman Brothers interest rate levels.

Given the interconnectedness of globalised credit markets, these macroscopic monetary trends – which in many respects follow the superficial global economic recovery of recent years from the lows of the great crash – really matter. They have a huge impact on the inclination of UK banks to lend. And this would be true even assuming the world economy avoids another slump in the short to medium term: a brave call indeed considering expert opinion strongly leans towards predicting a recession at some point in 2019 or 2020.

The borrowing needs of UK SME’s have traditionally been met by banks, through loans and overdrafts. Access to credit is often simply the axel grease of managing cashflows when projects or payments are delayed, when there are interruptions in the supply chain, or simply for when unforeseen events of any kind occur. It can also of course be required to fund expansion or provide operating capital to ride out challenging periods.

So, if there is a liquidity squeeze coming it’s essential for small businesses in particular – who lack the fallback assets and last-resort lending privileges of big corporations – to manage liquidity risk. There are three key areas to think about: financing facilities, cash flow forecasting and liquidity buffers.

Financing facilities – above and beyond the traditional overdrafts and credit lines – come in many different forms, accompanied by differing costs and conditions. There’s the often-expensive option of short-term loans, which require rapid repayments within months. Then there’s reaching into your own pocket – or those of your shareholders – for cash if things get challenging, as well as releasing equity in property. Depending on your companies age and reputation, there’s the possibility of Accounts Receivable Loans – i.e. borrowing against confirmed sales and contracted incoming capital. You also might – if you enjoy a strong relationship with a supplier – agree a trade credit facility with them. However, there are obvious problems with incurring so many forms of debt: for example, how long do you need the financing to be maintained? Will it be available on a continual basis at the same terms and conditions? Are the maturity dates of your financing facilities staggered so as to not leave you with a huge unpayable bill?

Cash flow is so vital to SMEs that it’s critical to maintain a sufficient liquidity buffer. This can either be cash, or some other very liquid assets that can be called upon when needed. Knowing where to draw the line between sensible precaution and overkill (that is, maintaining an onerously large buffer) is of course challenging, but professional consultants can help you find the right balance. However, in our view SME’s would do well to err strongly towards caution, particularly given the likelihood of recession in 2019 or 2020.

A further great risk mitigator is a cash flow forecast, something we advise every SME to maintain. This involves the continual monitoring of expected cash flows and comparing them against the annual operating budget, enabling red flags – that is, areas where actual cash flow and forecasts are out of sync – to be identified before it’s too late. While maintaining the constant flow of up-to-date information to the accountant tasked with managing the forecast is challenging and resource-hungry, such precautions could give you vital warning signs before it’s too late.

A Second Line of Defence

Liquidity problems have been the undoing of innumerable businesses in the past, and will be for innumerable ones in the future. This is especially true if a credit crunch catches fair weather companies off guard. You can mitigate liquidity risks with the options above, but will they be enough?

There are other financial de-risking mechanisms on the market (such as interest rate swaps and FX hedges), but none are capable of providing protection against a significant trading downturn combined with a liquidity shock. For this reason, Trade Profit Stabilization (TPS) was designed as an innovative – and easy to set up – mechanism, which is particularly appropriate for small businesses, giving them access to defensive measures previously only available to large companies. A TPS protected business is buffered in the most efficient possible way from the drying up of credit lines, while segregated asset backed funds supporting TPS are ready and waiting to support your business through the difficult times and back into trading success.