This week Scott Ochsner, the Loan Program Manager here at Meda, provided some insight about business liquidity during the COVID-19 crisis and some answers to the common “What should small businesses do when their funding runs out?”
Two terms that need to be defined when discussing this topic are: Liquidity and Solvency.
A liquidity event creates an immediate need for cash and is short term. Cash usually buys time for healthy businesses to get back on their feet.
Solvency, on the other hand, is a longer-term problem where the business model does not work. A cash injection into an insolvent business just means it will take a little longer for the business to fail.
“For some businesses, COVID will be a liquidity event. For others, business models will change in a way that in turn, creates a solvency problem.”
And as Scott says liquidity events and solvency issues are vastly different animals.
Meda’s Director of Business Solutions, Uri Camarena states that “Cash is king.” And Scott echoes echoing this sentiment when it comes to liquidity. The current business environment has us all thinking about liquidity, or a cash reserve sufficient to cover our bills while we deal with the effects of COVID19. There is a general concern about the lack of an adequate cash reserve that most small business owners have available to them when an unexpected problem creates a cash drain.
How much cash should a small business have on hand?
Scott says a common rule of thumb is enough cash to cover 3-6 months of operating expenses. The golden rule is to “never let liquidity become a problem” by keeping enough emergency cash to get your small business through liquidity events.
However, Scott sees that businesses rarely keep this much cash (or cash equivalents) in reserve. Small businesses often have a counterargument to holding this much cash. Business owners think the cash should be put to use by investing it instead of holding it. Scott offers a rebuttle to this common train of thought, “if you have dry powder, there will be times where you will be in a position to earn high returns by investing when others can’t.”
An example is the 2008 downturn in the US economy. It was a time when many had taken on too much debt and the environment then changed suddenly and forced massive deleveraging. This classic liquidity squeeze created some fantastic bargains. So, if small businesses had cash for down payments, stable cash flow, and a clean balance sheet, they could buy investment property (or stocks, or commercial equipment, etc.) at a fraction of what is was selling for prior to the crash.
During this COVID19 crisis, we could very well have an event that could impact prices and create bargains. But, right now, most asset prices have been remarkably stable. Scott believes this is largely because the Federal Reserve is flooding markets with literally trillions of dollars to maintain liquidity across the system. But as Scott sees it “the vultures are still circling, looking for an opportunity to deploy their dry powder.”
The unexpected is not all that unexpected
Liquidity events are sudden and unexpected, just like the COVID19 pandemic. While this instance is unique because we were not expecting anything like it and the scale is overwhelming, liquidity events are not as rare as we may expect, Scott explained.
Consider some events that might not seem so far-fetched:
- A loss of your biggest customer. Worse yet, you lose your biggest customer and they don’t pay their last bill.
- A flood or fire.
- A road construction project diverting traffic away from your (retail) facility.
- A scandal involving the business owner or a key employee.
- A horrific crime occurring on site.
- A restaurant serving contaminated food.
In a 10- or 20-year business career, one of the above, or something similar is going to surprise a small business owner, and the chances of one of these events happening are quite high.
How to deal with a liquidity event:
Scott’s number one tip is to “not expect a loan to bail you out.” There is way too much truth in the saying that you can only get a loan when you do not need it. In a liquidity crisis, small businesses need equity and reserve funds – in liquid form.
Scott provides recommendations on how to increase this equity and reserve funds:
- Drawdown any unused lines of credit (before the lender cuts you off).
- Stretch your accounts payable. Talk to creditors, landlords, and suppliers about any payment delays. Always keep communication lines open. Most will be willing to offer some accommodation as long as you can communicate a clear path to getting back on track.
- Address the problem.
- Pay close attention to accounts receivable. Especially customers that are having trouble paying you. You might stop selling to some customers.
- Maximize the return on the working capital you have (especially for construction companies). Increase the turn rate and rate of return you earn on your working capital by targeting fast pay projects/customers and higher profit margin projects.
Continue working with your Meda consultant through this dynamic time to stay on top of the most recent rules and regulations for small businesses. If you have additional questions about how to handle a liquidity event, contact Scott Ochsner directly at: firstname.lastname@example.org