Liquidity Management: Help! My Company Is Running Out of Money

All companies experience liquidity problems at one point or another. A cash crunch is just part of the business cycle, particularly in industries such as retail and construction where seasonality is part of the way things are done. 

But a liquidity crisis is amplified when business fundamentals begin to deteriorate, warns Rudy Morando, a Senior Vice President at Deloitte CRG, the Big Four firm’s corporate restructuring group. “During these times, it's more difficult to diagnose the problems." 

“The scary thing is when management is in denial from admitting deteriorating fundamentals and keeps referring to [the reason] as seasonality," adds Sugi Hadiwijaya, also a Deloitte CRG Senior Vice President. "When CFOs know the difference . . . they’re positioning their companies for better liquidity during a crisis.”

The two US-based turnaround specialists engaged with CFO Innovation’s Cesar Bacani in an e-mail conversation. Edited excerpts:

In a turnaround situation, you advise management to press forward and not be afraid of making an imperfect decision.

Morando (pictured): In a true liquidity crisis, a company’s ability to quickly take action to stem cash burn and instill confidence in stakeholders is critical. Often, however, management sacrifices taking immediate action because of imperfect data. They’d rather wait until analyses are perfect before taking action.

"I would challenge CFOs to quickly identify their own company’s liquidity troughs and develop back-up plans to avert them"

But delay can cause more harm than good. It sometimes prevents a successful turnaround and often hurts the inherent value of the business.

Hadiwijaya: One of our past clients was a large chicken processing company in the US. When Deloitte was hired in late 2008, management was hoping for corn prices to be favorable before executing a turnaround strategy.

Feed prices skyrocketed in 2008 due to increased ethanol production [which use corn as raw material]. That had a big impact because feed accounts for 40% of a chicken company’s costs.

However, we decided to restructure the company through Chapter 11 immediately, instead of waiting for corn prices to be favorable. Today, the company has emerged from bankruptcy providing full recovery to all stakeholders.

Morando: A few years ago, I was an advisor to a US-based jewelry manufacturer. Historically, this manufacturer was a dominant player in the industry, exceeding US$1 billion in revenue per year. However, we were called in when the business shrunk to just US$150 million in annual revenues.

The business fundamentals were shifting and competitors were either being acquired or moving their workforces to Asia to benefit from lower labor costs. Our turnaround plan called for a reduction in force and a shift in manufacturing from the United States to Asia.

The CEO was fiercely loyal to his employees. His preference was to put the company up for sale, an effort that would cost him his job but hold the possibility of saving the jobs of the employees he cared about.

In the end, he sold the company at a time of distress, causing a lower sale value.

It’s difficult to fault the CEO for his decision. Unfortunately, the sale to a local competitor didn’t provide a long-term restructuring plan; it simply pushed the burden of developing the plan onto another firm and temporarily preserved the employment of his work force.

Following our strategy to shift manufacturing to Asia – while imperfect in his eyes – would have provided a better platform for a successful turnaround and a lasting business model.

Not all liquidity problems lead to, as you put it, a “true liquidity crisis,” right? How may a CFO distinguish between a temporary crunch that is caused by seasonality and one that is likely to be far more serious because it is caused by a fundamental shift in the business?

Morando: Large-scale liquidity challenges are typically caused by one of two things.

First, management didn’t have the foresight to see an imminent liquidity crisis caused by deteriorating business fundamentals or by an industry dynamic that unexpectedly changed. Second, management did not have the ability or time needed to bridge a liquidity trough.

While seasonality can place a short-term strain on liquidity for some industries (e.g., construction, retail), it is often understood and planned for by the respective business and their lenders. 

Hadiwijaya: As a simple example, we can look at an individual. Assuming a status quo salary situation, an individual may increase seasonal spending to fund a vacation. Or he may shift spending entirely, reducing liquidity to purchase a larger home.

When we put it in a personal perspective, it is fairly clear to distinguish change caused by seasonality or a business fundamental shift. Good management teams should be able to explain the same for their businesses.

Morando: The challenges with seasonality are that an initial cash outlay is required to fund inventory growth; time is required to convert inventory into a receivable; and you need time as well to turn receivables into cash.

To avoid a liquidity crisis, develop the tools required to provide visibility into cash levels before they are ever needed.

The weekly cash flow has historically been a tool used only in times of distress. However, we now see healthy companies invest in this type of forecasting as a way to proactively squeeze as much working capital improvement out of the business as possible.

Is seasonality a more likely cause of liquidity problems rather than deteriorating fundamentals or an unexpected shift in industry dynamics?

Morando: In my experience, liquidity tightens because of seasonal challenges quite frequently. It’s fairly commonplace in several industries, so it isn’t something that we typically get called in to assist.

That said, a liquidity crisis is amplified when business fundamentals begin to deteriorate. During these times, it’s more difficult to diagnose the problems with the business. It’s also more challenging for management to communicate these struggles to stakeholders.

The weekly cash flow forecast can be used to manage liquidity as well as communicate with lenders, rebuilding trust to successfully navigate through a transitional period.

Hadiwijaya (pictured): The scary thing is when management is in denial from admitting deteriorating fundamentals and keeps referring to [the reason] as seasonality.

When CFOs know the difference, identify deteriorating fundamentals early and ring the alarm, they’re positioning their companies for better liquidity during a crisis.

"We find that banks often manage cash during a liquidity crisis on a bank basis, which poses several issues"

You recommend producing a 13-week cash flow. Why 13 weeks, specifically?

The 13-week period reflects one quarter and typically captures a company’s working capital cycle. However, certain industries might have a longer cycle, thus requiring a longer-term cash flow forecast. For example, a cash flow for retailers might need to be longer to capture holiday-related seasonality.

Morando: I serve as an instructor for Deloitte’s 13-week cash flow training program as well as our long-term three-statement modeling course. In every course I remind the class that every model is wrong, but some are useful.

When we deal will short-term forecasts like the 13-week cash flow, accuracy is paramount. Missing the forecast could lead to an inability to make payroll, or ultimately, to lost credibility with your stakeholders.

How long, typically, does it take to prepare a 13-week cash flow forecast?

Hadiwijaya: The preferred timeframe is two weeks. However, stakeholders might want to see a forecast in less than two weeks.

There have been instances when we’ve prepared a forecast in an abbreviated, under two-week timeframe. Typically, when we deliver under such short time frames, we prepare a forecast of just 3-4 weeks, then follow with a longer 13-week cash flow in the following week.

Morando: In my experience, two weeks is an appropriate time to work with management, to understand the business and to build and test a detailed model. Doing so in less time can obviously be done. But the accuracy of the model will be sacrificed.

Is the 13-week cash flow forecast something that you have to build from scratch?

Hadiwijaya: I once interviewed a college graduate without turnaround experience, asking how he’d develop a personal cash flow for himself. His answer was: “Well, I have an inflow line for my salary and then cash outflows for my rent, car payments, weekend activities, food, clothing and occasional gifts for my girlfriend.”

I then asked him: “What is the most important item that you’d need to develop this cash flow?” His answer: “I need to know about myself.”

That same concept must be understood by CFOs. When they develop their company’s cash flow forecasts, CFOs need to know about the company’s underlying drivers and working capital movements.

We have a template for standardized formatting, but the calculations (i.e., the brain) of the model are typically unique and built from scratch. A cash flow forecast for a retailer with minimal or zero receivables is different from that of an aerospace company with long lead times.

"We once worked with a company treasurer whose cash management technique was to run checks, then stuff them into his desk drawer until someone called looking for payment"

Morando: During times of rapid growth and prosperity, company leaders rarely focus on the cash flow; their focus tends to be on the income statement. Often, it isn’t until the business cycle progresses and liquidity tightens that management realizes it has neglected the cash flow.

In liquidity emergencies, CFOs can feel stressed that they’re unable to solve every problem that pops up. Prioritizing in two areas can help: determine when the liquidity trough occurs, and understand what can be done to avert it.

I would challenge CFOs to quickly identify their own company’s liquidity troughs and develop back-up plans to avert them. If there aren’t resources or experienced professionals in an organization to help, it’s likely time to hire an outside professional.

How does Deloitte CRG do a forecast? Do you have your own proprietary tool?

Morando: The key to developing a quality weekly cash forecast is to understand the inputs and outputs before an Excel spreadsheet is ever opened.

We’ll typically have an initial meeting with key managers to outline important line items in the forecast and to ensure that we have the ability to capture the actual results required as an input in the weekly variance report. This is called model mapping.

Having this foresight allows for a more streamlined weekly reporting process, ultimately allowing for the faster development of weekly variance reports.

You advise managers to be realistic and conservative in making assumptions as inputs to the forecast. Why?

Morando: Now is not the time to chase a rainbow’s elusive pot of gold. Including exponential revenue growth may allow people to view the forecast through rose-colored glasses, but unless the projection materializes, it will never provide the business with a foundation that’s strong enough to support a turnaround.

Developing any projection will require assumptions and judgments by the management team and its advisors. It’s critical that those assumptions be grounded in reasonable analytics and clearly defined for everyone to see.

We teach our professionals to include a detailed set of assumptions in our cash flows; this is especially important when the forecast deviates from historic run rates.

Hadiwijaya: I always come back to the saying “cash cannot lie.” In certain situations, management can book sales and EBITDA results to match their forecast, but projecting unrealistic cash movements will eventually catch up with the company.

For example, if a construction company applies a percent completion methodology to its projects, aggressive revenue and cost recognition techniques may be applied in certain months. However, the amount of cash inflow will ultimately depend on the allowable billings stated in the contract, which is driven by milestones that both the company and customer agreed upon.

You also suggest that CFOs use the direct cash flow method in developing the 13-week forecast.

Morando: In practice, there are ultimately two standard cash flow types used by companies – indirect and direct. When using a near-term cash flow of 13 weeks or less, our preference is to use the direct cash flow method.

Direct cash flow receipts and disbursements (i.e. payroll, rent, insurance, taxes) are clearly listed as line items in the cash flow. This aids management in holding employees accountable for progress against plan.

The indirect methodology would only show changes in balance sheet accounts (e.g., change in accounts payable, changes in accruals, change in pre-paid). This would be more challenging for stakeholders to understand and for management to execute against.

Why do you advise that the company should not print and hold checks?

Morando: When businesses are flush with cash, habits are developed where checks are cut for all payments due. When liquidity tightens, the process becomes more complicated. There are often times that require careful review of what can be paid, sometimes requiring vendor negotiations. 

We once worked with a company treasurer whose cash management technique, to preserve and improve the company’s cash position, was to run checks, then stuff them into his desk drawer until someone called looking for payment.

The problem with this technique was that it distorted the company’s liquidity picture and put the business at significant risk. The checks were removed from accounts payable and lost in “float” that the treasurer couldn’t quantify.

Further, there was always risk that his assistant would enter his office, find a check on his desk and place it in the mail – never knowing whether or not the company had the cash to cover the payment!

Businesses should only print checks they intend to pay. The process of printing and holding checks is a dangerous cash management strategy.

"If the company has ample collateral, it may be able to refinance its debt with a new lender at improved borrowing rates" 

Hadiwijaya: Another scary practice on understating accounts payable is leaving invoices unreconciled or un-entered. Whether the omissions from the general ledger are intentional or not, they can cause significant challenges in supplier communications and overall cash management.

What is the reason for your recommendation to prepare the cash flow on a book basis, not a bank basis?

Hadiwijaya: When we say “book basis,” we refer to checks disbursed during the week. Once those checks are disbursed, they should be considered “cashed.” However, we find that companies often manage cash during a liquidity crisis on a bank basis, which poses several issues.

Morando: The only difference between using book and bank basis is the inclusion or exclusion of float (checks cut but not yet cashed).

The reason to use the book basis is to be able to properly understand and communicate to stakeholders the cash position of the business if the proverbial clock stopped today.

The idea is simple: if operations stopped today, how much cash would the business have to address outstanding liabilities? In times of distress, the answer to that question is important to stakeholders.

Hadiwijaya: Playing the “float” game can push companies into negative liquidity and can make it difficult to track variance to budget.

Cash disbursement on bank basis shows how many checks cleared during the week instead of how many checks were disbursed (book basis). It is practically impossible to explain any variance on bank basis.

You referenced the need to negotiate new payment terms on debt. What are some of the ways to do this that you have found most effective?

Hadiwijaya: Selling a turnaround story to stakeholders is an important step in securing new debt terms. Stakeholders must buy into the story.

After the story is successfully sold, it’s also important that milestones be set to illustrate management’s ability to successfully implement the plan. The 13-week cash flow can assist in this process.

One successful strategy is to prepare a liquidation analysis to illustrate minimal recovery if the restructuring plan is not implemented. The high cost of a bankruptcy filing can also be used to prompt investors to pursue out-of-court restructuring plans.

What about refinancing loans?

Hadiwijaya: If the company has ample collateral covering its loan position, it may be able to refinance its debt with a new lender at improved borrowing rates. We have successfully seen companies refinance their revolver. This is based on an alternative lender perceiving the collateral to be of higher quality, thus providing better advance rates and improved liquidity.

Lenders worry about their collateral coverage and will weigh the cost/benefit of a liquidation or a restructuring. Risk tolerance differs among lenders; thus, understanding the profile of lenders helps.

Note that turnaround professionals can add value to lender profile analyses, due to their frequent interaction with lenders in difficult situations.

Shouldn’t companies communicate with lenders and other critical stakeholders regularly anyway, regardless of whether or not they are facing a liquidity crisis?

Hadiwijaya: Based on my conversation with lenders, a monthly call appears adequate to keep stakeholders apprised of key developments and to maintain quality relationships.

I recently gave a presentation to a nationwide lending team for a midsize bank, where some people in the audience stated that it is very helpful for them to understand the company’s operations. They prefer to be invited for factory tours and to see their borrowers’ operations in-person.

In my experience, having a knowledgeable lender will help a company during a liquidity crisis.

In a crisis, disinformation and rumors tend to be commonplace. Efforts to mitigate this risk could include sharing additional information with stakeholders and more frequent conversations with employees.

Most of the time, management wants to avoid difficult conversations. Unfortunately, the only way to stop gossip from spreading is to be proactive in sharing information clearly and consistently.

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