Liquidity Dynamics During a Period of Uncertainty

fdu’s guest blogger, David Tilston is a Chartered Accountant, a Fellow of The Association of Corporate Treasurers and a member of The Institute for Turnaround. He has held CFO roles in both listed PLC and PE-backed companies and has significant experience of managing turnaround situations.

I have recently written on the importance of developing weekly rolling cashflow forecasts. We are now moving past the stage of immediate crisis response into a period of protracted uncertainty. This blog uses illustrative forecasts of various scenarios to highlight some cashflow dynamics which might help in decision making by Boards of Directors.

Base case liquidity scenario

I have constructed a simplified base case model predicated on a manufacturing company which generated £24m of turnover and a cash operating margin (ie before non-cash items such as depreciation) of 10% annually before the COVID-19 virus struck.

I have assumed it has subsequently suffered a 40% decline in turnover and severely cut its cost base (including using government support measures) so that it is operating at approximately cash breakeven on an annualised basis.

Debtor balances are received around the end of the following month, and creditors are paid to a similar timetable. The business carries approximately one month of raw materials, WIP and inventory and it starts the forecast period with £300k of cash resources. There will be weekly and monthly fluctuations (for example the assumption of property rents payable quarterly at June and September month ends).

My base case scenario projects cash balances at the end of every week (starting with week ending 26 April) as follows:

The conclusion directors may draw is that the business can continue to operate safely and survive with a small cash cushion for the foreseeable future providing there are no significant changes in the trading environment.

Sharp rebound liquidity scenario

I now take the same illustrative financial model but work on the basis that the directors have received information at the beginning of May which allow them to conclude that there will be a sharp bounce back in sales starting in June (up 30% from May levels). The directors decide that they therefore need to order more materials and increase manufacturing from the beginning of May to meet this demand, and reverse some of the short term cost cuts previously implemented so they have sufficient capacity. The sharp rebound scenario (compared to the base case scenario) is shown on the graph below.

This projection gives the directors a problem. Despite the fact that they will be earning greater accounting profits from June onwards given the higher sales, the extra cash generated from increased profitability is insufficient in the short term to fund the additional working capital requirements.

The business runs out of cash in June, and even if it is able to arrange short term overdraft facilities, its cash position does not exceed the base case scenario until late in the calendar year.

“Extra cash generated from increased profitability is insufficient in the short term to fund the additional working capital requirements.”

Slower and faster sales rebound impact on liquidity

So what is the position if we consider a slower rebound in sales?

Instead of a one off 30% rebound in sales in June I have modelled a slower rebound in sales (5% monthly increase in June, July and August) and a faster rebound (10% monthly increase in June, July and August). The slower sales rebound scenario assumes a 15%+ cumulative increase in monthly sales by August and the faster rebound a 30%+ cumulative increase over the same period.

In both cases monthly cash profitability increases.

The slower rebound scenario shows that the business can just about manage this within its existing cash resources (providing it can take some temporary action at the end of September to avoid cash balances briefly dropping into negative territory – ie company has run out of cash).

The faster rebound scenario is more problematic as, although it ends up with more cash at the end of the projection, its deficit is much greater at various points and it would require some short term financing (which may or may not be available).

Assumptions need to be dynamic based on current intelligence

In my final dynamic scenario I have taken the slow rebound assumption of anticipated 5% sales growth in June and July. I have then assumed a major customer becomes insolvent in August and monthly sales fall 10% to around their earlier level (accompanied by cost cuts following a previous increase in costs to cope with higher sales).

The company also suffers a bad debt which means that cash receipts previously expected will not now arise and so need to be removed from the earlier cash forecast.

The dynamic scenario shows less cash at the end of the forecast compared to the base case. This is because the extra cash generated from the short term increase in sales is less than the amount of cash receipts lost as a result of the bad debt.

“Judgements will need to be dynamic and management teams agile.”

Some concluding observations on above liquidity scenarios

The financial model and assumptions above have been compiled for illustrative purposes only and do not purport to represent a realistic outlook for any specific business.

Businesses from different sectors may have quite different assumptions and commercial drivers from those depicted above. I would urge you to take away the following points:

  • The volatility of cashflows can be much more significant than the volatility of accounting profit measures – the knock on impact on working capital needs to be carefully scrutinised.
  • At some point a recovery will come – the more rapidly sales recover the higher the risk of a short term cash crisis due to working capital requirements.
  • We could be in for a prolonged period of uncertainty when it will be difficult to assess what the right assumptions should be at any point in time. Judgements will need to be dynamic and management teams agile to meet the challenges and exploit the opportunities within the cash constraints of their business.
  • Review your cashflow forecasts at least weekly.