Economic Concepts III

Understanding Liquidity

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In the "Rules to Live By"section of this site, my first comment is related to liquidity.  What is liquidity?  It is not a beer on a hot day.  It is not watering the lawn.

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Liquidity is the ability to lay your hands on actual cash in a very short period of time.  I have worked for people worth tens of millions of dollars who could not raise $100,000 in 24 hours.  I have also worked for people worth tens of millions of dollars who told me they would need at least 24 hours to come up with $3.6 million.  One had liquidity, one did not.

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In a business crisis (think fire or loss of a large customer) liquidity is everything.  If you want to purchase assets at deep discounts (real estate in the great recession) liquidity is everything.  If you want to attend your arch rival's bankruptcy auction, liquidity is everything.

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Let's look at two companies.  Same size in the same industry.  Same net worth.  Same fixed assets.  Same earnings power.  How are these two companies different when it comes to liquidity?

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ABC Manufacturing Co., Inc. (ABC) is a very strong company.  Very little bank debt.  A nice mix of current asset relative to current liabilities.  A very low debt to equity ratio of .36, ultra low by traditional financial measures. 

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DEF Manufacturing Co., Inc.  (DEF) is a strong company in its own right.  A very strong cash position.  A nice mix of current assets relative to current liabilities.  A debt to equity ratio of .67, almost double the debt to equity of ABC.

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So which company is stronger?  By most traditional measures, ABC is the stronger company.  Better balance sheet and little bank debt.

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Let's say a pandemic hits the nation.  The markets fall 50%.  The government imposes lock downs.  Employees refuse to report to work.  Sales collapse. 

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I know, I know.  What is the chance that could happen?

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ABC has $400,000 in cash and accounts receivable.  DEF has $1,050,000 in cash and accounts receivable.  How has more staying power in the pandemic?  Who has greater LIQUIDITY available?  Get the picture?

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Now of course DEF has higher debt and bank payments.  They also have more cash to make those payments and tough it out over an extended period of time, say a full year. 

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DEF has more debt, but also greater LIQUIDITY.

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Now, you may be reading this and raging "ABC can simply go borrow the money and tough it out like DEF..."

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Wrong.  Very wrong.  In the chaos of a pandemic, severe recession, or an inflationary spiral it is highly likely the financial system will be in a defensive posture. 

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A close friend of mine ran a bank.  He ran a tight ship and when the great recession came his rock solid bank was in a position to go on offense.  Banks were sending clients out the door and he was ready to welcome them with open arms.  He waited years for this moment.

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His board of directors directed him to remain defensive.  A recession was no time to put the bank's capital at risk.

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Need I say more?

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Get liquid.  Carry strong working capital positions.  Carry some long-term debt.  Be prepared to go on offense when everyone else pulls back.

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Liquidity.  Liquidity.  Liquidity.

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