Liquidity

The concept of liquidity is reasonably simple; do you have enough cash or readily available funds to pay your outstanding debts?

What are these debts that require paying? We all know about payments to banks (mortgages, bank fees & overdrafts), we know about the costs of running business (wages, electricity, gas, rent, rates, telephone, capital items, IT, tax, and maybe freight & repairs) and the cost of maintaining customers (product innovation, product development and time to cultivate relationships). But what other activities affect a business’ liquidity?

Working capital in the form of debtors and inventory (both high levels and obsolete stock) are high on the list of activities that suck liquidity out of businesses. Both of these needs to be monitored and actioned, as they represent cash tied up that could be better used in the business. Non-prioritised or misdirected capital allocation initiatives (commonly know as special initiatives or the boss’ pet project) can also considerable reduce an organisations liquidity. Other less considered business sponges are poor governance or compliance leading to incidents and opportunity costs, brought about by lack of focus or lack of time spent working on the right things at the right time.

All activities in business require the investment of time, money, personal energy and business resources. If they do not produce an acceptable rate of return, then all these activities run the risk of destroying the business’ liquidity and indeed the life of the business.

SME’s with their limited access to resources must carefully consider the number of projects undertaken. This means projects undertaken must be certain to build greater value for the business than the project not undertaken. But how are these decisions made? Small businesses need some tools to help with assessing what to invest in. The two I believe that are important are Return on Investment (ROI) and what the risk of the investment is. ROI considers the gain from the investment when compared against the cost. Its simple formula is:

ROI = (gain from investment – cost of investment)/cost of investment

A high ROI means the investment gains compare favorably to investment cost. In purely economic terms, it is one way of considering profits in relation to capital invested. It can also be used as a comparison tool to judge competing projects and to assess which will give the biggest bang for buck. This metrics is useful for short-term investment. In projects considered over a longer timeframe (years), Net Present Value or NPV, which is the value of the cash flow over the term of the investment, also needs to be considered to determine the wisdom of the investment.

However, with all investment comes risk and an understanding of what those risks are, is also important. If a project or initiative delivers great rewards, but has a high chance of causing business failure, this needs to be considered when picking investment options. Unfortunately there is no simple metric identifying which initiative or project will potentially propose the greatest risk to the business. This needs to be a process completed by those who understand the change being implemented and those who will be affected by the outcome. In the assessment, the resultant consequences of the outcome need to be evaluated by all those involved. It is worthwhile noting that risks are normally seen as negative threats, but they can also be positive opportunities.  Gambling is an example where the risk is to lose your money, whereas the positive opportunity is to increase your money investment.  Note that both types are bound together by their impact and probability, and should be included in the risk management analysis.

Comparisons of project ROI’s and the risk factors ensure business ties up resources in ways that will benefit the organisation.

Lastly, small businesses need to focus on their most profitable products, best clients and key suppliers within their most promising markets. This may seem obvious but many businesses are reluctant to alter their business models to accommodate this blatant reality. Inertia, culture and ego are the principle culprits and ironically clients, products, suppliers and markets pose some of the greatest risks to small businesses.

Please Contact Robert Carter on This email address is being protected from spambots. You need JavaScript enabled to view it.  if you would like to discuss any of this or would like to review any part of your business on my 16 Point Checklist.