Liquidity Crises Management

What is a liquidity crisis?

A liquidity crisis occurs whenever a firm is unable to pay its bills on time or lacks sufficient cash to expand inventory and production or violates some term of an agreement by letting some of its financial ratios exceed limits. It is the financial manager's job to ensure that this never happens. But it happens and all interests involved start to scramble to protect their positions.

Consider the following example:

SITUATION This company has received a call from its bank informing it that the company has violated some terms of its loan agreement, specifically, that debt ratio exceeded 55% and that the current ratio has fallen below 2.0. These ratios are highlighted in the table of ratios below.

Technically the bank could call the loan for the complete amount outstanding . If the company cannot repay in ten days then it could be forced into bankruptcy. You are surprised at this turn of events since you were going to the bank tomorrow anyway to ask for for an additional $1,000,000 to meet a payment due to the construction company working on the expansion of your facilities.

You will have to calculate whether you would be able to repay the existing loans to the bank and the additional money you want to borrow within six months if you could get your average collection period in line with the industry average and also do the same with your inventory turnover. Assume that you will generate cash from operations and depreciation at the same rate that you did last year for one half year.

FOREST RESOURCES CORP. BALANCE SHEETS
amounts in thousands of dollars	1993	1994	1995
CASH	807	628	612
ACCOUNTS RECEIVABLE	2682	2896	4605
INVENTORY	2970	5181	7319
LAND BUILDINGS PLANT & EQUIP	2786	3153	3558
ACCUMULATED DEPRECIATION	470	730	1050
TOTAL ASSETS	8775	11128	15074
SHORT TERM LOANS	500	800	2860
ACCOUNTS PAYABLE	1061	1648	3137
ACCRUALS	540	800	1150
LONG TERM BANK LOAN	1000	1500	1500
MORTGAGE	450	408	367
COMMON STOCK[3.65 MILL.SHS]	3650	3650	3650
RETAINED EARNINGS	1574	2322	2410
TOTAL LIABILITIES AND CAP	8775	11128	15074
-	-	-	-
INCOME STATEMENTS
	1993	1994	1995
NET SALES	26820	28996	30703
COST OF GOODS SOLD	21216	23550	26140
GROSS PROFIT	5604	5416	4563
AMN AND SELLING EX	2006	2407	2648
DEPRECIATION	250	260	320
MISC EX	318	558	898
EBIT	3030	2191	697
INTEREST SHORT TERM	50	88	286
INTEREST LONG TERM	0	150	150
INTEREST MORTGAGE	41	37	33
NET INCOME BEFORE TAXES	2939	1916	228
TAXES	1411	919	110
NET INCOME AFTER TAXES	1528	997	118
DIVIDENDS	382	249	30
INCREASE IN RETAINED EARNINGS	1146	748	88
Ratio Analysis
	1993	1994	1995	INDUSTRY AVG
-	-	-	-	-
CURRENT RATIO	3.07	2.68	1.75	2.5
QUICK RATIO	1.66	1.08	0.73	1
DEBT RATIO %	0.4	0.46	0.6	50
TIMES INTEREST EARNED	16.79	3.63	0.25	7.7
INVENTORY TURNOVER[COST]	7.14	4.55	3.57	4.7
INVENTORY TURNOVER[SELLING]	9.03	5.6	4.19	7
FIXED ASSET TURNOVER	11.58	11.97	12.24	12
TOTAL ASSETS TURNOVER	3.06	2.61	2.04	3
AVERAGE COLLECTION PERIOD	36	36	54	25
PROFIT MARGIN %	5.7%	3.4%	0.4%	2.9
GROSS PROFIT MARGIN %	20.9%	18.7%	14.9%	18
RETURN ON TOTAL ASSETS %	17.4%	9%	0.8%	8.8
RETURN ON OWNERS EQUITY %	29.2%	16.7%	1.9%	17.5
DIVIDEND PAYOUT RATIO	25%	25%	25.4%	20%

Using Logic to Attack this problem

This situation is a problem for the company and the bank:

• The company has a problem because it owes the bank more than the amount of cash available.
• The bank has a problem because this company has become a problem loan and causes additional burden from bank regulators.

What are the alternatives?

1. Bank calls the loan.
2. Bank gives company more time but does not lend additional money needed.
3. Bank lends additional money and does not call the loan.

If the bank calls the loan the company has ten days to come up with the money. There is not enough cash so they might seek another bank to arrange financing. However with the lousy financial ratios they have at the present time, no sane banker would lend them the money. The company would default [not be able to pay], and bankruptcy would start. The bank may have to wait years and only recover a small percentage of what is owed.

If the bank does not call the loan the company will still be unable to meet the progress payment to the contractor who will then probably start the bankruptcy proceedings anyway. So alternative #2 really is not viable in this case.

If the bank lends the additional money, the crises will be averted for the moment, but how will the bank be able to protect its interest? And, is it really throwing good money after bad.

The bank is in the driver's seat and will have to make a quick determination if the company is better off dead or alive.

Method of Analysis

Facts

• Poor Management of Accounts Receivable.Average Collection Period
• Poor Management of Inventory.Inventory Turnover Ratio

What needs to be discovered

• How much cash would be produced if the Accounts Receivable and the Inventory were lowered to a proportion consistent with the Industry Average?
• How much cash will be gained or lost from operations while the Accounts Receivable and Inventory are reduced?
• Is the total cash potential above greater than the total amount owed the bank and the contractor?

Actions

• If the cash potential is greater than the need, force an change in management and make additional loan.
• If the cash potential is less than the need, start bankruptcy proceedings immediately!

Calculating the Cash Potential

The important thing to realize is that the existing management is much worse than the industry average. If the company were managed at the industry average level there would be a lot less receivables and inventory. Inventory would be sold off and old account balances would be collected.

Amount of Cash Available from Receivables
Actual Accounts Receivable	[from the balance sheet]	4605
Ideal Accounts Receivable	[ind ACP times avg. daily sales	2132
Cash potential		2473

Amount of Cash Available from Inventory
Actual Inventory	[from the balance sheet]	7319
Ideal Inventory	[Sales divided by ind Inventory turnover	6533
Cash Potential		786

Amount of Cash Available from Operations
Estimated net income	[one half of last year's]	59
Depreciation	[one half of last year's]	160
Cash Potential		219

Decision Table
Total Cash Available	[sum of above three tables]	3478
Total Cash required	[sum of bank loans + amount due contractor]	3860
Decision		Bankruptcy

Implementation

If the decision is made to go with bankruptcy it is basically a legal process to protect the rights of all the creditors.

If the decision is made to continue in operation the bank must do something to insure that the old way of managing inventory and receivables stops

from:http://academic.uofs.edu