The Power of Liquidity Cash is King! Why liquidity is a key component of a financial strategy.
The Family Wealth Alliance 2011 Fall Forum Chicago, Illinois October 12-14, 2011
The Power of Liquidity
A Sobering Reminder When the great financial crisis of 2007-08 finally began to ease in the U.S., some icons of Wall Street were gone: AIG, Lehman Brothers, Washington Mutual. Others had been bought at fire-sale prices: Merrill Lynch, Bear Stearns. Many more survived only with a government rescue through TARP funds: Citigroup, Bank of America, JPMorgan Chase, Goldman Sachs, and of course Fannie Mae and Freddie Mac. Victims – or creators? – of the financial meltdown. These once storied franchises with vast reserves of capital and liquidity had taken various routes to – or over – the brink of insolvency. But they did share something in common. They all fell prey to one of the oldest missteps in the financial playbook: not enough access to liquidity during a crisis. In fact, a liquidity shortfall in U.S. banking had triggered the entire financial crisis. It had been brought on by the collapse of the housing bubble and the free fall of prices because of a lack of buyers, that is, “creators of liquidity.” The big names grabbed most of the headlines in the Great Recession with their bankruptcies and bail-outs, but they were not alone. Countless smaller companies and individuals suffered similar fates, hurt by the decline in the stock market and housing, plagued by business failures, and beleaguered by the destruction of untold personal wealth. The economic disaster shook the financial industry, dried up credit and spooked investors. It remains a sobering reminder of just how important liquidity is. But the truth is, financial pain due to insufficient liquidity happens all the time, not just during great upheavals. And it usually catches its victims by surprise. That’s why the prudent person of means and the well-run company know what liquidity is, understand its importance, and execute a plan to acquire and maintain the right level for their circumstances. Success in this area will not only keep you off the financial page (unless you want to be there as a buyer of distressed assets), it will propel you to achieving your financial or business goals.
The Power of Liquidity What is Liquidity? Liquidity, in simplest terms, is the ability to meet your financial obligations, or pay your obligations when due. It is commonly thought of ready cash or the ability to convert assets to cash quickly. Can you get your money when you want it? The most liquid asset, of course, is cash, in its electronic form. We measure other assets against it. This is because we can always use cash easily and immediately. On the other end of the scale are assets such as real estate or an operating business, which might take months or even years to convert into cash. In between is a whole range of assets. The following table shows assets, generally from most to least liquid.
Liquidity of Assets Less
Hedge Funds Gold (physical)
Harder to Convert
Real Estate (pre-2007)
Unimproved Land Real Estate (post-2007)
Private Equity Investment
Common Stock Mutual Funds
Easier to Convert
Machinery and Equipment
Short-term Bonds Cash Value Life Insurance Certificates of Deposit
Company Receivables Company Inventory
Line of Credit Bank Accounts Cash Source: TriState Capital Bank
On the list, two factors figure importantly in the conversion of the asset: time and marketability. Assets with the least liquidity cannot be sold quickly, or cannot retain their full value if sold quickly, or have no ready market at all. As a general rule, the more buyers and sellers there are for an asset, the more liquid it is and the closer one can come to realizing its full value in a sale. Most lenders consider anything that can be converted into cash within a reasonable period as liquid.
The Power of Liquidity For the sophisticated person of means, though, liquidity is more complicated than a simple scale. Liquidity is multifaceted and consists of financial resources - unrestricted cash reserves and lines of credit—one can access in a short period of time. When making an investment, one should consider how easy or difficult it will be to exit the position. A truly liquid asset will have a buyer ready when, or even before, the seller needs to liquidate it. Another important point about liquidity: it is not a constant. For the investor, that means understanding the variability of liquidity and keeping current with the portfolio of assets to understand the liquidity level at any point in time in a changing financial environment. In finance, there is also the loosely defined concept of liquidity risk. That’s the chance that a given security or asset cannot be traded quickly enough in the market to prevent a loss, or make the required profit. For a company, liquidity is its ability to meet maturing short-term obligations. So it’s a comparison of the firm’s current assets and current liabilities. A company risks losing liquidity if it experiences sudden, unexpected cash outflows, if its credit rating falls, or if some other event causes customers, suppliers or lenders to cease doing business with it. A firm is also exposed to liquidity risk when markets on which it depends lose liquidity. Studies show that the operating inflexibility caused by highly illiquid assets is an important source of risk for companies. Firms need to remain solvent. But with too many illiquid assets, a liquidity gap or mismatch may occur, when dates for inflow and outflow of funds do not match up, creating a shortage. Finally, there are systemic liquidity risks arising from external factors. Recessions, credit crunches, capital market disruptions, Bear Markets, negative press, trade interruptions, and political tensions and military action can all have a large impact on liquidity.
The Power of Liquidity Why is it Important? A prudent level of liquidity puts one in a strong financial position. It allows more options to take, more leverage to use. Even the most astute business or financial manager cannot see every threat in the making or every crisis on the horizon. The recent financial turmoil demonstrated that a liquid portfolio is crucial to one’s financial survival. It just as forcefully showed how quickly and dramatically the world financial picture can change. If the legions of financial experts employed at dozens of megabanks and investment houses couldn’t see the crisis coming in time to avoid being caught short of cash, there’s no reason to assume that middle market business managers and investors will do any better...unless they are prepared. That’s why one needs to make strength in liquidity a cornerstone of the financial plan, a permanent component of the portfolio. It will tide you over in a pinch, cover your costs in a sudden drop in cash flow, let you weather a downturn in the market, and give you the wherewithal to meet the demands of investors and creditors. You should assess your future capital needs and determine the amount of ready cash required to handle small or severe shocks. Liquidity also lets one reverse investment decisions. It provides an exit option one might not otherwise have.
The Power of Liquidity
Those are largely defensive reasons. There are a number of positive factors to recommend liquidity too. Cash on hand can let one take advantage of unforeseen opportunities when they arise. There are always opportunities to be seized and bargains to be had. In difficult times they abound. But the people who might benefit most from them don’t always have the ability. They are often strapped for cash, lacking financial strength. Remember, during financial stress, for every loser in a transaction, there’s a winner. Again, during the recent upheaval that was just as true as at any other time, maybe more so. Those with the financial might to cash in will be on the winning side of deals, more often than not. This is just as true for companies as for individuals. Cash gives firms the ability to innovate at the opportune moment to gain market share. They don’t have to wait for the funds or juggle assets to secure the money. Also, companies with sound liquidity almost always enjoy a lower cost of capital. That’s crucial. Not only can they get funding more easily, it costs less. And that savings goes right to the bottom line. Just ask your banker. He or she will tell you liquidity is the number one factor banks use in judging the credit worthiness of a business, followed by cash flow. It’s just as important as net worth. Finally, studies show that businesses with more liquidity have higher value than businesses with less, as a direct result of that liquid strength. Illiquid real assets can result in an inflexibility in operations that constitute a source of risk.
The Power of Liquidity How Does One Measure Liquidity? Finance managers measure liquidity in several ways. They use ratios to judge how easily a company can meet its current obligations. Many of these metrics can be applied to High-Net-Worth Families.
The Main Measures are: Current Ratio: Current Assets to Current Liabilities Current usually means collectible or payable within one year. It varies by industry, but good liquidity often means a company with a current ratio of more than two. To the financial expert, this is a sign that a company can meet its obligations and is not likely to run into financial difficulties.
Quick Ratio: Current Assets (excluding inventory) to Current Liabilities The quick ratio, sometimes called the acid test ratio, is a bit more stringent. Among current assets, inventory is the most difficult to convert into cash. So it is not included in the computation of current assets. Again, it varies by industry, but a quick ratio of greater than one is usually considered good.
Cash Ratio: Cash + Cash Equivalents to Current Liabilities This is a company's total dollar amount of cash plus marketable assets divided by its current liabilities. It is a good barometer of a companyâ€™s ability to liquidate assets quickly to cover its needs in the short term.
Debt-to-Equity Ratio: Liabilities to Equity This is frequently defined as total liabilities divided by stockholders' equity. It is an indirect measure of a company's liquidity. Typically, companies with a higher debt-to-equity ratio will be less liquid, because more of their cash must be used to service their debt.
The Power of Liquidity How does one create liquidity? For individuals, creating or increasing liquidity is largely a matter of harvesting positive cash flow. This is not always a simple process. Less liquid assets, by definition, are more difficult and take more time to divest at the desired price. So a plan of action with a defined strategy and a clear time line is needed to carry out a liquidity build. Most important, you need to be sure you don’t suffer undue losses in wealth by taking poorly timed action. That’s where an advisor comes in. The advisor can offer guidance on how to create and maintain proper liquidity levels. For companies, creating or increasing liquidity is a different matter. There are a number of steps companies can take, as shown on the following table.
Actions That Create Liquidity for Businesses - Generate positive cash flow - Reduce overhead - Sell unproductive assets - Collect accounts receivable - Negotiate longer accounts payable terms - Improve profitability - Arrange lines of credit - Borrow against assets - Evaluate liquidity of assets before investing
Can one Lose Liquidity? Yes. It can happen as a deliberate action, conscious of the risks involved, to take advantage of opportunities that only more illiquid assets can serve. Often, a downward shift in liquidity comes about through no action on your part at all. If the liquidity of your primary market falls, your liquidity can fall with it. The best defense in this case is a good offense. Put a sound plan together, one that places liquidity as a prime strategy, and work that plan month-in, month-out to make sure you have the financial resources – and peace of mind – to meet your long-term goals.
The Power of Liquidity
How Much is Enough? The level of liquid assets one should keep on hand depends largely upon one’s estimated needs. In a nutshell, one wants enough to achieve his or her goals and to avoid financial unanticipated set-backs. Here are some common guidelines. On a personal level, most financial advisors recommend that an average person have cash on hand equal to at least six months’ living expenses. For a person of means, it’s more like three or four times that amount, at a minimum. That’s because people of wealth are apt to have complicated portfolios with more illiquid assets that could take more time to liquidate at a favorable price, should an emergency force them to cash in some assets.
The Power of Liquidity
For companies, the situation is different. How does one determine adequate liquidity for one’s business? Here are three guidelines.
Transaction Requirements Make sure there’s enough cash to pay for planned expenses, such as payroll. Look at the budget and cash flow forecast. Judge if that will change in the short term. Then compare the cash flow to the cash reserves and decide if there’s adequate funding. Precautionary Requirements Here one wants to determine if there’s enough liquidity to meet unplanned events and expenses. Try to anticipate events that might impact income or expenses, and then quantify the reserves needed if those events occur.
Speculative and Opportunity Requirements At this level one asks if there is available cash to pursue unexpected opportunities. This could be expansion, innovation, or business openings. Companies with this capacity are the ones with the greatest potential of growth.
When one has figured the requirements at the three levels, the total is the projected liquidity to maintain in cash reserves and short-term investments. If one doesn’t have that amount, develop a plan to get there. It may be appropriate to open and use a line of credit to meet your liquidity needs. To this thinking we at TriState Capital Bank can have some fun and add additional insight based on the long and varied careers our experienced staff has with individuals and businesses. The table on the following page shows how we in banking commonly view a potential client’s liquidity status when we evaluate their credit worthiness. It demonstrates how important liquidity is to a business and the desired levels shown often surprise even experienced business owners and managers.
The Power of Liquidity
Ratio of Income and Liquidity to Annual Needs +5x
In the Catbird Seat
Safe and Secure
Still Squeak By
Walking a Tightrope
Sound the Alarm!
The Power of Liquidity
Can One Have Too Much? It’s possible to overdo even a good thing, including liquidity. Turning all one’s assets into cash is seldom the best strategy. If it were that simple, everybody would liquidate to cash, with little income in this environment and no productive assets. What’s the downside to too much liquidity? To begin with, liquid assets generate little or no return. Cash brings in close to nothing. And in recent years, safe, liquid investments, like bank accounts and certificates of deposit haven’t fared much better. They have fetched very low returns, often near zero. Even during periods of high interest, they seldom beat inflation with their return and they usually bring in a much lower return than other investments. Stocking up on cash may help one through a bumpy patch, but it won’t sustain one for the long term. Low risk equals low return. Also, being too rigidly fixed on maintaining a specific liquidity level may cause a person or company to miss out on good opportunities. Cash may be king. But even a king has some limits. There are times when exchanging liquidity for high-potential investments for oneself or one’s business is the right move. There are other factors that should figure into one’s investment calculation. As always, there are trade-offs, especially for business owners. Liquid assets don’t make products or profits. And therein lies the paradox of liquidity. On the one hand, lenders and investors want to see the liquidity that adds strength and stability to a firm’s portfolio. On the other hand, they could conclude that a business doesn’t have the productive assets in place to bring in a good return. And it is profitability that ultimately provides value for investors. So business owners need to understand markets, investors and banks well enough to optimize their asset portfolios and maximize profits.
The Power of Liquidity
How Can a Bank Help with Liquidity? A good banker can help a person or a business in several ways. When one has a relationship of trust with a banker who gets to know the person and business, one receives personalized service. Banks can help you manage liquidity. A good bank will offer attractive deposit terms and competitive loan rates. It will make available liquidity management services. And it can extend lines of credit to use as part of a liquidity strategy. TriState Capital Bank specializes in these services. Our founders built their venture precisely for these purposes. We offer a full suite of customized banking solutions delivered with personalized service through a team of experienced professionals with a deep understanding of banking and business. For executives and individuals, for family offices, and for wealth management firms we extend a full array of lending services, deposit products and our private banking team. Yet even with this one-on-one service approach, we offer all the convenience of modern finance with the technology our clients expect of a full-service bank.
The Power of Liquidity
How Does one Create a Financial Strategy that Maintains Adequate Liquidity?
First, Surround Yourself with Trusted Advisors Not only can advisors offer expertise and experience. They and the resources of their firm can provide an objective, detached view that you cannot bring yourself. Second, Know your Current Liquidity Position at All Times Use one or more of the ratios we discussed earlier to understand your liquidity level and use that information in your planning. Third, Make Maintaining a Strong Liquidity Level a Central Part of Your Plan Set a liquidity minimum based on your current and projected needs, and a liquidity target for anticipated actions and potential emergencies. Finally, Know the Liquidity of Assets before Investing to Make Sure They Support your Liquidity Goal That can be a little more difficult than it seems. Not all options in the same investment class have the same liquidity.
The Power of Liquidity One other useful visual aid for planning your liquidity is the TriState Capital Bank Cash Flow Liquidity Coverage graph in Table 4. Itâ€™s a visual for evaluating projected liquidity over a five-year horizon. No set of numbers is right for everyone, but from our extensive experience we believe this information is a good guide for getting your liquidity right for your long-term financial success.
Cash Flow Liquidity Coverage
Time 1 Year
Growing War Chest or Minimal Depletion
No Wiggle Room or Margin of Error
Potential for Disaster without significant change in sources, uses or needs
Source: TriState Capital BankÂ
The Power of Liquidity
Conclusion For individuals and businesses, liquidity is financial power. It gives you strength to act, power to defend your position, capacity to seize opportunities. It puts you in â€œTHE CATBIRD SEAT.â€? It should always be central to your financial plan. The key to success is finding the right balance of assets for your needs, your goals. Make no mistake. Liquidity yields not just power, but speed. The speed to act quickly and decisively to expand, to change direction, to grow. And it is usually the swift who not only succeed, but lead.
Why liquidity is a key component of a financial strategy