There’s perhaps no worse feeling of dread than being short on cash. Even worse than not being able to cover the check at a restaurant is not being able to pay next week’s payroll or meet loan obligations. For companies facing a real liquidity risk, there are proactive steps and liquidity risk mitigation strategies to follow, to reduce the risk of getting in such a situation.
Know the Different Types of Liquidity Risk
What does it mean to have liquidity risk? Another way to ask this is: How could your company end up in a situation where its funds are tied up and it’s not able to meet its many obligations? Here are some situations that can arise, which helps to know when devising risk mitigation strategies:
- Frozen financing: If you haven’t met debt covenants or haven’t made a strong case to lenders, you may find yourself at a roadblock for a much-needed loan.
- Clogged cash flow: A lack of proper cash flow management is a surefire way to let more cash out of the company than is coming in.
- Being turned away from lenders, investors: Being in noncompliance with debt covenants could cause a downward spiral if other lenders aren’t willing to take a chance on your company. The terms that you agree upon will affect your liquidity as well.
- Market issues: Despite the best forecasts and optimistic outlook, some market conditions can have an adverse effect on your business.
- A bank run: While bank runs may be reminiscent of “It’s a Wonderful Life,” the banking crisis of 2023 proved that history can repeat itself—and companies can be vulnerable if their cash is largely tied up with one financial institution.
How Do I Mitigate Liquidity Risk?
- Buy into the mantra that “cash is king.” It may be a cliché but it’s proven to be true time and again. Constantly forecast the cash that is coming in and going out while managing any spikes and dips. Account reconciliations and collections need to be up-to-date so that the amount of cash you truly have is known. Keep watch on the cash balance, and don’t just focus on the P&L (too many startups have made this mistake for it to be repeated).
- Diversify financial institutions. Silicon Valley Bank’s rapid failure from being the 16th largest bank based on total assets to falling under government control and acquired by First Citizens Bank brought to light an important lesson: Don’t let your funds be tied up in one place. By diversifying banks, you can spread out your liquidity risk if an issue does arise with your main bank.
- Stay on top of best practices. Understanding and identifying liquidity risks, aiming for high liquidity, keeping watch over your liquidity, and having proper internal controls are some of the many ways to stay on top of the risk and have a plan in place in case an issue arises. For startups, consultants who have been through a range of experiences, in various market conditions, are full of best practices and expertise that can be applied to your unique situation.
Mitigation of liquidity risk can start with a complete understanding of the ratios you are monitoring, those you should be monitoring, an assessment of your financial planning and analysis efforts, and perhaps more frequent forecasting of cash flow. Experts in cash flow management can take a look at your processes, including those with payables and receivables, to see if any improvements should be made, along with contingency plans if liquidity becomes an issue. To understand your company’s current liquidity risk and ways to mitigate it, see how RoseRyan can help.
