Causes of the dry up of company liquidity

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1.        Question 4

1.1    List and explain causes of the dry up of company liquidity (10 Marks)

The liquidity of an organization could simply be defined as the ability to make payments as they fall due (Moir 1997, p. 1). The company liquidity attracts sufficient attentions from the business sector and research filed because a company may be highly profitable in an accounting sense but it is of no use if there is no cash to pay the employees and suppliers and for further reinvestments which could directly lead to the cease of business. In the most recent global financial crisis, severe liquidity problem is also involved in the early stage. It is commonly believed to have begun in July 2007 with the credit crunch, when a loss of confidence by US investors in the value of sub-prime mortgages caused a liquidity crisis (Canstar.com.au 2009). Hence it is important to list and rationalize the causes of the dry up of company liquidity to better understand the root reasons of the financial crisis. Below let us look into the reasons behind the company liquidity problems or crisis.

 

1.1.1            Over-expansion of credit and the following sales drop

 

Figure 1 ABS issuers, home mortgages and other loans

Source: OECD, DataStream

 

Take the US property market as an example, originated from the distortions and incentives created by the previous policy actions, there was a veritable explosion in residential mortgage back securities (RMBS) since 2004 as the figure above shows, anticipated price surge come together with fast expansion in credit and mortgages, when such growth is not anticipated as sustainable by the investors the crisis begin and the sale decreased. When the sale drop happen, it is common for companies who had previously expansion the investment by borrowing money to become incapable to clear the debts when they are due.

 

 

 

1.1.2            Stricter bank lending policies

 

As mentioned in the case in the question, under an early stage of a crisis the company failures in the beginning usually appear of little consequence but after the following an apparently benign period, other issues appear that together trigger a bad economy situation, one of these issues that lead to the company liquidity problems is the stricter bank lending policies. For example, with the collapse of some giant TNCs in the late 2008 and early 2009, lending policies of banks in the US became stricter and more conservative thus hitting almost every industry. As commented by Hugh Dickerson, General Manager of Sales and Marketing at Al Futtaim Motors operator of Toyota, Lexus, Hino and BT franchises, “There’s no particular sign at the moment that banks are going to start lending” (Zawya.com 2009) and such stricter lending policy had impacted even Toyota, the largest auto maker nor to mention the medium and small producers and their downstream distributors and upstream suppliers. As reported in February 2009 that many banks have made it harder for borrowers to obtain all kinds of loans over the past three months despite a $700 billion federal bailout program and a flurry of other bold moves to stem the worst financial crisis to hit the country since the 1930s (Idsnews.com 2009). With increased difficulties in getting bank loans while sale is dropping, it is understandable that companies will finally running out of liquidity to meet the due liabilities.

 

1.1.3            Drying up of the capital inflows

 

Companies in the developing countries were also impacted by the severe financial crisis in term of drying up of the liquidity due to the reduced foreign investments. For example in India, one of the most popular destinations of global investments, the initial impact of the subprime crisis on the Indian economy maintained rather muted. But with the deepening of the crisis and the worsening of the financial conditions across the globe capital inflows as the figure below tells.

 

Table 3 Indicators of liquidity in India

Source: RBI (2009), annual report

 

As the companies in India or even the whole economy is supported by the foreign investment capitals, the sudden drying up of the inflow will definitely bring impacts to the companies relying on these investments. And similar cases could also be found in other fast developing economies such as China.

 

1.1.4            Credit rating being lowered by credit rating agencies

 

Credit ratings measures a company’s ability to repay its obligations and directly affect that company’s cost of and ability to access unsecured financing. And the judgments made by the independent credit rating agencies such as Standard & Poor’s could contribute to the liquidity crisis for the business entities. For example, AIG, which had been the largest underwriter of commercial and industrial insurance in the United States suffered from a liquidity crisis when its credit ratings were downgraded below “AA” levels in September 2008 (Bojicic 2010, p. 167) because that the downgrading of the credit rating affected the company’s ability to raise funds and increase the cost of financing its major insurance operations and in turn impeded AIG’s restructuring efforts (McCool 2011, p. 76). Definitions of the ratings by the three of the credit rating agencies, Moody’s, S&P and Fitch that accessed the creditworthiness of AIG are given below in the table. Similar cases could also be found in the failures of other many large organizations in which the downgrade of their credit rating seemed to bring sudden liquidity crisis to them. But as it is the credit rating agencies’ job to evaluate the companies’ ability to repay their obligations, so it is more appropriate to conclude that the downgrade of the credit ratings are facilitators to the liquidity crisis rather than one of the root reasons to the failures.

 

Table 4 List of the rating agencies’ ratings

Source: McCool 2011, p.76

 

1.2    Explain how firms should address the area of credit controls (10 Marks)

 

According to the Australian Securities and Investments Commission, 9,829 companies entered external administration in the 2011 financial year, up 5.9% in 2010 in Australia. In June alone, 1,027 companies entered administration, registering the worst month in insolvency terms since early 2009 when the global financial crisis was at its peak (Startupsmart.com.au 2011). The ASIC blamed particularly on the Australian Taxation Office, which tightened the debt recovery and cracked down on tax-evading small businesses as it seeks to recover millions in debt. The initiative of the tightening tax collection policy according to a consultant’s report was to reduce the bad debts through early intervention in the debt collection process which had been proved as a significant factor in contributing to a reduced number of bad debts owing and this is because the more a debt becomes completely unmanageable, the less likely that it is that the debt will be paid. The report also found out that in 2010 by the implementation of the so called “early collection” help decrease the average debt by $9100 or 26% of the average debt (Debtcollectionletter.com.au 2010). Though the Tax Office claimed that the debt collection policy is directed towards identifying and applying the most appropriate debt collection response to each particular case with regard to the individual circumstances (Igt.gov.au 2005), but due to the limits of resources allocated by the Tax Office compared to the large number of companies involved, the impacts on the liquidity for companies are almost certain. While other creditors would also have similar credit control methods with their own reasons to avoid higher risks, there are some techniques that companies especially the medium and small sized ones could do to cope with the credit controls and build good credit control into the daily business operations.

 

1.2.1            Clearly set and manage the expectations

 

It is better for any company to well monitor the average period that it takes for them to receive the payment after the successful delivery of goods that they provide to the users or customers. By long term monitoring and also taking into the consideration of the nature of the industry that the company is operating in, a company could be able to decide a standard term within which the payments would generally be made. What is more, a company can clear state the payment terms in term of standard term and conditions or contracts and also make them written in very invoice to remind the customers the company’s expectation of the payment after the delivery of the goods. In the long run to avoid the bad debts, it is also necessary to monitor the customers’ reliability by rating the credit of the customers based on the history transaction records. On the other hand, companies could also try to manage the expectations of the creditors such as the banks and tax department by negotiation and communication which should be executed in a proactive manner. Even though due to the insolvency problems in difficult  time a company may not have enough of cash to cover the full debt, partial payment by negotiation could transmit a message to the creditors that the company is engaging in finding ways to clear the debt which in many cases are much better than doing nothing.

 

1.2.2            Make it easy to be paid by providing more payment options

 

Limited payment methods could push the customers to defer their due payments because of the inconveniences incurred. There are many ways that a company can accept payment from customers though not every payment method is a viable option for a particular company. Some frequently accepted types of payment options that could be accepted include credit cards, debit cards, checks, money orders, online payments, cashiers’ checks, and cash. And in term of the amount of payment to be made though it is always a good idea to have a standard payment policy that applies to all customers which will state that it is the customers’ duty to make the full payment within the stated term (Berthiaume 2011). But as what has suggested above, partial payment should be accepted if the customers have good transaction records and reputation, it is recommended that the company do three things. The firstly thing is to show empathy to the customers regarding their difficulties, this is important to maintain a long term partnership relationship; the second task is to provide some flexible payment methods such as partial payment to the customers; one more jobs to be done is to communicate the standard payment policy again to the customers to make sure that it is still the customers’ responsibility to make the full payments next time.

 

1.2.3            Encourage prompt payment

 

It is possible to negotiate favorable payments terms with some customers by guaranteeing delivery within a tight timescale or in compliance with a schedule to meet the company’s liquidity needs (Morris, McKay & Oates 2009, p. 138). Convenient methods such as direct debit or discount schemes could be adopted to encourage prompt or early payment. But the management of the company need to take note that is may not be appropriate to make such convenience and benefits available to all the customers, but rather they should be differentiated to the individual customers based on the importance of the customers, credit rating of the customers and other factors. This is to avoid much financial loss together with the aim to build up better customer relationship.

 

1.2.4            Have a clear procedure for credit control

 

In the of the implementation of the credit control policy, to maintain an effective management of the receivable a company should lay down clear-cut credit procedures. Every credit needs to be sanctioned only through the credit procedures made by the firm (Talekar 2005, p. 127). Though exceptional handlings do exist and sometimes they are also necessary to maintain the customer relationship especially those of great importance to the business of the company, it is critical to standardize the procedure for credit control which helps manage the expectations of the most customers in normal situations.

 

 

1.2.5            Take action when it is necessary

 

A comprehensive and clearly defined procedure for credit control should state the actions that would be taken by the company as a creditor to recover the loss which should adhere by the company accordingly. For example, with 1 week overdue the company would send reminder letter and telephone the customer when it becomes two weeks etc, and warning should be followed up by substantial actions when the overdue continues. Serious actions such as legal actions should be taken withou prior and advanced notice as stated in the procedures, the legal actions should be done with determination to in accordance with the policy as prescribed to demonstrate the company’s firmed position in term of credit control.

 

1.2.6            Treat credit control as an important job every week

 

To treat the credit control as an important job every week is to keep the credit control relative tasks and jobs as part of the routine job and carry out the planned precess as planned in advance. It is about the firmed and carefull implementation of work. As  mentioned above, the very beginning of the credit control is the well management of the expectations of the customers and creditors, and this requires a lot of communications jobs and intergration of the relative values and ideas into the daily work which will need to be done in the daily work. But the fact this that many companies would be busy with the business operations and put this aside until the solvency problems happen.

 

 

 

 

 

 

1.3    Identify and explain telltale signs of a company in trouble with liquidity (10 Marks)

 

1.3.1            Skinny profit margins

 

As liquidity is defined as a company’s ability to quickly convert assets to cash so that it can pay back the bills and meet other debt obligations such as mortgage payment on a bill or a payment due to bond investors (Langdon, Bonham & Epstein 2008), income in term of profit is obviously one of the most important souce of the cash used to pay the bill and meet the deb obligations. When a company shows a decreasing and skinny profit margins continusly, investors may need to notice that this company may probably have liqudity problems in the future.

 

1.3.2            Low reinvestment ratio

 

While the indicator profit margin shows a company the current and very near future abilty to genearate cash that helps meet the debs obligations, a low reinvestment ratio not only mark the company’s insufficient profit the be allocated in the reinvestment activities but it also indicates that the company would probably not enjoy a growth in income and profit due to the reinvestment would hopefully bring in new source of income and profit generation.

 

1.3.3            Extremely low cash flow ratio

 

Cash flow ratios assist a user in understanding relationships and trends amon a company’s cash flows which could be act as an indicator of the company’s liqudity situation (Nikolai, Bazley & Jones 2010, p. 286). Below in the table are four of the frequently used cash flow ratios. For example the Cash flow from operations (CFO) to sales ratio evaluate the cash generated from sales and the management of cash collections and payments. This CFO to sales ratios is higher than the profit margin due to the noncash expenses such as depreciation are deducted in computing net incomes. Similarly, other types of cash flow ratio together could help the individual and instituational investors to access the safety of the company’s liqudity. And it should arouse the investors’ attention and concern when these ratios are running in an unusual low level.

RatioFormula
Cash flow from operations to salesCash flow from operations / Sales
Cash flow from operations to net incomeCash flow from operations / Net income
Cash flow from operations per shareCash flow from operations / Average shares of common stock outstanding
Cash flow from operations to maturing debtCash flow from operations / Debt maturing next year

Table 5 Cash flow ratios

Source: Nikolai, Bazley & Jones 2010, p. 286

 

1.3.4            Extremely high gearing ratio

 

One example of a gearing ratio is the long-term debt / capitalization ratio, which is calculated by taking the company’s long-term debt and dividing it by its long-term debt added to its preferred and common stock (Thefreedictionary.com 2009). A company that has a higher leverage ratio would be considered as riskly and may trigger liqudity problems because they have more debs and relatively less equity indicating that when the deadline of the debt comes the compnay may probably be put under liquidity problems. Another problme that come with the extremely high gearing ratio is that the creditors of the particular company would notice this abonormal gearing ratio and probalbly would turn to stricter credit control policy such as early payment requirement which would in return trigger the liquidity crisis to the company and increase the future fund raising cost to the company.

 

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