Liquidity: some less obvious questions to ask

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 13 week cashflow forecasts for managing short term requirements. I now look at some of the less obvious questions to ask to ensure short term liquidity is not jeopardised.

What should I be aware of when I draw my Revolving Credit Facility (RCF)?

When you draw down an RCF facility (and indeed certain other facilities) you complete a utilisation request form which typically includes certain confirmations. These would normally include a statement that no Event of Default (as defined in the agreement) is outstanding and all representations and warranties (again as detailed in the agreement) remain true in all material respects.

The Event of Default definition will normally cover:

(a) that no financial covenants have been breached

(b) that there have been no misrepresentations to the lender

(c) that no creditors (above a de minimis level) have commenced proceedings against the organisation (including its subsidiaries)

(d) financial accounts do not contain any audit qualifications and

(e) a wide variety of other matters have not occurred (including circumstances arising which could have a material adverse effect).

The legal wording will be extensive and requires careful reading. In normal times most companies would have no difficulty in making the above representations. We are however not in normal times and representations which could have previously be made with ease might not be possible in the current environment.

“Representations which could have previously be made with ease might not be possible in the current environment.”

The question organisations should therefore consider (most probably with their advisors and lawyers) is whether they are confident they will be in a position to be able to draw on their RCF facilities if they need additional liquidity. If there is any doubt there is an argument that all funds should be drawn down whilst the organisation is legitimately able to and the resultant cash balances placed on deposit.

Organisations may also want to consider any contractual set off arrangements they have with their lenders, and also credit risk matters, before they decide where they wish to place their deposits.

Please note that similar representations and warranties are typically repeated on loan rollovers, and some discussion with the relevant lender will be required if these representations and warranties cannot be given on an unqualified basis. The lender may technically be able to declare an Event of Default at that stage, and some dialogue and external advice may be required to agree a mutually acceptable approach (if possible), possibly in the form of temporary waivers to specific obligations.

How much liquidity is available under my Asset Based Lending (ABL) facility?

These facilities are structured differently from bank loans as they are more dynamic and the underlying rationale is that the ABL provider will provide funds based on the relevant assets within the business. A key question to ask yourself is “have I got sufficient headroom in my cashflow to trade now and overcome any road bumps along the way?” One of the advantages for the client is that an ABL facility is flexible such that more funding can be advanced when there are seasonal peaks in the business and working capital naturally increases in line with increased trade.

“Have I got sufficient headroom in my cashflow to trade now and overcome any road bumps along the way?”

ABL facilities involve timely reporting obligations so the ABL provider understands the asset base at any point in time.

Short term business fluctuations will need to be watched carefully. The recent reduction in economic activity may, in certain business activities, have led to a reduction in the overall asset base of the ABL’s client as debtors have been paid and current sales revenue is lower than in previous months. Some outstanding debtors may have aged to an extent that they are no longer treated as eligible assets under the ABL facility. Inventory levels may also have been reduced on the back of lower turnover. Some ABL clients will undoubtedly be operating at a loss currently, with cash operating costs exceeding cash receipts so this is where headroom and 13 week rolling cashflow forecasting becomes even more necessary.

“An ABL facility is flexible such that more funding can be advanced when there are seasonal peaks in business.”

As and when an economic recovery gets underway companies are likely to see an increased demand for working capital. Depending on the working capital cycle raw materials may need to be purchased and inventory increased before increased sales can occur. Liquidity will be drawn under the ABL facilities to help fund supplier payments and get the business moving forward again, but this can only occur if the asset base is sufficient to support requests to ABL providers.

Careful modelling of various assumptions and scenarios is required to understand how the availability of funds under an ABL facility might vary depending upon circumstances. Engagement and a good relationship with the ABL provider is imperative so it becomes easier to determine whether they are prepared to grant forbearance (in the current economic circumstances) on specific constraints or availability calculations.

Could the actions of Trade Credit insurers have an impact on my liquidity?

Trade Credit Insurers are capable of indirectly impacting a business’s liquidity.

Some suppliers may be dependent upon trade credit insurance to bear most of the credit risk against their customers becoming unable to pay their bills as they fall due. If any trade credit insurers reduce the amount of risk they are prepared to take against your business, and cut their credit limits available to your suppliers, the suppliers may either reduce the amount of product they are prepared to supply or ask for payments in advance (adversely impacting your cashflow).

“The suppliers may either reduce the amount of product they are prepared to supply or ask for payments in advance (adversely impacting your cashflow).”

The same issue could arise for your business in its relationship with your customers if you manage your credit risk with trade credit insurance and customer limits are reduced.

Additionally, if you are financed by an ABL facility which requires customer receivables to be insured, a reduction in trade credit insurance could potentially reduce the amounts available under your ABL facility (unless the ABL provider is prepared to be flexible).

Should I worry about my pension deficit in the short term?

If you have a defined benefit pension fund which is in deficit then the Trustees are likely to be monitoring the company’s ability to continue to make deficit reduction payments within a pre-agreed schedule. Any significant restructuring of the financing arrangements of the company may also require the involvement of the Trustees, and possibly also The Pensions Regulator, and this is an area where specialist advice is certainly required.

In summary

Although 13 week rolling cashflow forecasts are an essential tool in managing short term liquidity other factors can come into play in these unusual times. The company needs to think laterally and identify those additional matters, which it might not necessarily review normally, and assess whether they need further scrutiny under current conditions.

“The company needs to think laterally…”

In addition the company may need to seek clarification or further flexibility from its liquidity providers and early engagement with those parties, subject to professional advice as necessary, is recommended.