A liquidity crisis takes place when a company is unable to finance its current liabilities with its available cash and hence defaults on payments. In the opinion of Kavan Choksi, to avoid insolvency, businesses must try to obtain enough funds as fast as possible in times of liquidity crisis. But doing so is not easy. Hence, it becomes vital for businesses to ensure that it is adequately prepared for a liquidity crisis, even in good times, so that cash shortages do not occur in the first place.
Kavan Choksi provides insights into how to steer clear of a liquidity crisis
A liquidity crisis can have many different causes. At times the issues lie with the company itself, while in certain cases, external events lead to liquidity crises. In order to prevent businesses from slipping into a crisis, it is vital to monitor their liquidity. Managers must know how high the cash reserves and cash flow of a business are at all times. They should also have a dependable plan that will help them to understand how income and expenditure will develop in the coming months so that they can determine in advance whether a liquidity crisis is developing or not.
A business must take certain precautionary measures that aid them in reducing the risk of a cash shortage.
Here are a few of those measures:
- Monitor accounts receivables: Monitoring the accounts receivable properly and managing them appropriately is vital to lowering the risk of cash shortage. It is possible to assess how long it takes on average for a business to be paid by its customers by calculating diverse key figures like Days Sales Outstanding. In case long invoicing periods lead to cash shortages, they can shorten with ease so that a company receives its revenues much faster and thus remains liquid.
- Smarter shopping and storage: Many businesses have to buy materials or goods in bulk and pay a good amount of money for it. Due to this pre-financing, lesser cash would be available to the business to cover their operating expenses, thereby giving rise to a liquidity crisis. To steer clear of such an eventuality, businesses must properly review their purchasing and storage strategy. It can often make way more sense for the business to order fewer goods or make purchases in shorter intervals so that less money has to be financed in advance. Just-in-time procurement might also be an option for certain businesses and allow them to save on warehousing altogether.
- Build up cash reserves: When the business is running well, it would be prudent to set aside a part of the income as a cash reserve. Businesses should ideally try to maintain six months of cash reserves that can be used for covering operational expenses in the event of heavy losses. Cash reserves provide business owners with a much-needed financial cushion to fall back on in case of an emergency and help them to avoid taking out an expensive bank loan straight away to meet their financial obligations.
On the whole, Kavan Choksi is of the opinion that if a business owner can keep a proper check on their cash flow, they can majorly reduce the risk of a liquidity crisis. A cash flow plan can also be drawn up to recognize cash shortages before they crop up.