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Liquidity management
Liquidity management

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3 Liquidity management: stress testing

Every organisation should have in place a contingency funding plan – a statement of how it would cope with an adverse movement in cash flows. Table 1 provides an outline of how such a contingency funding statement could look.

First, liquidity conditions are measured under both normal and adverse business conditions. In adverse conditions, an organisation would expect to have lower cash inflows arising from its business activities because of lower sales and/or lower prices than under normal conditions. Additionally, it might expect its access to funds to be reduced owing to the reduced appetite of lenders to fund the organisation during an adverse trading environment. For the purposes of this exercise, it is assumed that unavoidable capital expenditure and holdings of liquid assets are unchanged between the two scenarios.

From these data, the organisation can assess how much cover it has from a combination of funding sources and liquid assets relative to its operating net cash flow. The management of the organisation (the board or its equivalent) can then set a minimum acceptable ratio of funding sources plus liquid assets relative to any negative cash flow. The objective is to ensure that this ratio is sufficiently high to ensure its continued survival during a prolonged period of adverse (or stressed) trading conditions.

Table 1: Liquidity management matrix
Normal trading conditionsStressed trading conditions
Free cash flow from operations (lower than X)XM
Unavoidable capital expendituresYY
Net cash flowX – YM – Y
Support from sale of liquid assetsAB (lower than A)
Support from additional borrowingCD (lower than C)
Available liquidity from assets and borrowingsA + CB + D
Liquidity plus net cash flow(A + C) + (X - Y)(B + D) + (M – Y)
Term until exhaustion (if net cash flow is negative)(A + C) / (X - Y)(B + D) / (M - Y)
Minimum term to exhaustion of cashBoard to defineBoard to define

A golden rule is to apply caution to the expected cash inflows: for assets that you envisage selling to raise cash it is appropriate to apply a worst-case analysis. This is because a forced sale of assets, where you need the cash quickly, is unlikely to raise as much cash as when assets are sold in non-emergency conditions. One way to accommodate this in liquidity management is to apply haircuts (or discounts) to the expected value of assets sold in difficult market conditions or at times when the organisation in question is known to be a ‘forced seller’. These haircuts are an estimate of the discount that may have to be applied to ensure a sale. More liquid assets should attract small haircuts – say up to 10 per cent of prevailing market value. Less liquid assets require a larger haircut to be applied for liquidity planning purposes – with discounts of up to 30 per cent or more of prevailing market value being prudent.

The liquidity management matrix shown in Table 1 is a simplified example of how an organisation can measure its exposure to liquidity risk and, ideally, manage that risk effectively. The example, though, reinforces two important points about liquidity management: first, it involves managing the maturity profiles of both assets and liabilities; second, there should be a policy approved by the board of an organisation (or its equivalent) to ensure sufficient liquidity is maintained on an ongoing basis.