How often do we hear this sad refrain from the CEO or CFO of an emerging growth company: “If only my Bank would expand my credit, all of my problems would disappear!”?
To be sure, a lack of liquidity to finance operations and growth can be a very real problem. I would like to suggest three ways you can prevent it.
Three Ways You Can Avoid Liquidity Problems
1. View Money As The Symptom, Not The Problem
Consider Newport Board Group’s Four Ms framework, which is designed to help emerging growth companies get out of No Man’s Land. One of the M’s is Money. The others are Market (the company’s ability to expand to new niches to support its growth); Model (its infrastructure to make money at greater scale) and Management (the ability of its executive team to deploy its founders’ capabilities). Many companies regard Money as the scorekeeper: when liquidity becomes tight they know there is something wrong. But Money in and of itself is often only the symptom.
When a company has liquidity problems, the cause may well be related to one or more of the M’s other than Money. It may have failed to develop a compelling value proposition for new market niches. Its operating model may have too much fixed and too few variable costs. Its management team may be made up of cronies of the founder, not professional managers who can take the company to the next level. Companies shouldn’t try to borrow their way out of trouble or try to “make it up on volume” without addressing the underlying cause of the problem.
So the first rule of managing your liquidity is to manage the fundamentals of your business relentlessly and understand how they affect liquidity:
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Value proposition: why customers buy your products over those of competitors in the same or a different category.
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Business model: your method of making and selling products at a profit.
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Cash conversion cycle: the process by which your business turns cash to pay for your costs into cash received from your customers. This is a key part of the larger process of managing your balance sheet.
2. Track Your Collateral
I have been involved in many situations in which growing and middle market companies get funding via asset-based lending and other collateralized credit arrangements, whether from banks or non-bank lenders. When these facilities are established, it is typical for the loan limit to be closely linked to the pool of collateral that provides security for the loan. This pool typically consists of Equipment, Accounts receivable and Inventory. With time and growth the amounts in this pool will change, often dramatically. Preoccupied with the challenges of managing growth, the borrower company may fail to monitor and manage the collateral pool.
By contrast with cash flow lenders, which are often content to maintain the borrowing limits in place and wait for other performance metrics to materialize before making any changes, Asset Based Lenders readily adjust their lending limits based on changes in collateral. In many cases, and particularly in hyper-growth situations, the borrower fails to see that the growth in collateralized assets like Accounts Receivable and Inventory has become a large drain on its cash flow. It may suddenly see the need for working capital to fund its increased Accounts Receivable and Inventory. The resulting cash crunch can result in irreversible damage.
3. Track Compliance with Loan Covenants
Most CEOs would say that they recognize that a strong working relationship with their lenders is based on two key ingredients: confidence and predictability. Yet all too often, management turns a blind eye to the detailed provisions of their borrowing covenants, which are the foundation for the lender’s confidence in them. As a result, they may find themselves at odds with their lender at the most inconvenient time i.e. when they need liquidity most.
In many cases this reflects shortcomings in the company’s financial reporting. Timely and accurate financial data and pinpoint working capital forecasting is essential for managing borrowing relationships. Too many companies become aware of a breach of their covenants only when it is too late.
In the next article in this series I will discuss other steps that companies can take to manage their liquidity and borrowings. If you would like to learn more about how to avoid a cash problem in your company, download the ebook below on How to Get and Keep Bank Credit. In this ebook you will learn how to approach funding with a 9 step road map specifically for emerging growth companies.
