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Looking for Liquidity

Focus Management Group - liquidity

With 2022 around the corner, companies need to plan for their working capital needs, and evaluate their loan agreements for future compliance. The combination of inflation, commodity price changes, labor issues, and supply chain disruptions have created new stresses on the operating cycle, and therefore, on the existing line of credit structures. They have also stressed financial performance which in turn could impact loan covenants tied to financial and operating performance.

Operating Cycle

Developing a monthly analysis of the operating cycle helps show management the impact of changes in accounts receivable, inventory, and accounts payable related to sales. Rather than using cost of goods sold to calculate the number of days invested in inventory and accounts payable, use sales. The approach of using sales to calculate the number of days sales invested in accounts payable and inventory reduces the impact of reporting certain expenses in the cost of goods sold portion of the income statement versus the operating expense section of the income statement. The approach of using sales in the denominator of the number of days formulas reduces the excuses management will have for reduced operating cycle performance and allows all parties to focus attention on the cash flow and operating cycle changes.

Walking through the calculation of the operating cycle and cash needs for a sample company is shown in the next section.

First for the operating cycle, begin with the number of days sales in accounts receivable, inventory and accounts payable.

Number of days sales invested in accounts receivable becomes:

(Accounts Receivable Balance / (Sales for the Period / Number of Days in the Period))

($9,700,000 / ($87,900,000/365)) = 40 days

Number of days sales invested in inventory becomes:

(Inventory Balance / (Sales for the Period / Number of Days in the Period))

($8,000,000 / ($87,900,000/365)) = 33 days

Number of days sales provided by accounts payable becomes:

(Accounts Payable Balance / (Sales for the Period / Number of Days in the Period)

($6,000,000 / ($87,900,000/365)) = 25 days

Then, the operating cycle is number of days in accounts receivable plus number of days in inventory less the number of days of accounts payables.

The operating cycle of a sample company is shown in this table.

Focus Management Group - liquidity

These calculations tell us the number of days sales the company must have available in cash or line of credit availability – assuming operations are at least at break-even performance.

Using the sample company, the amount of cash or line of credit needed is shown in the next table.

For 2018, the $11,700,000 of cash or line of credit needs is calculated as follows:

(Sales of $87,900,000 / 365 * 49 day operating cycle in the previous table) = $11,700,000

Focus Management Group - liquidity

Using an estimated line of credit availability of 85% of accounts receivable and 60% of inventory with modest ineligibles, an estimated availability under a line of credit structure is prepared.

Subtracting the estimated availability from the cash or line of credit needs shows the amount of cash a company must have on hand to operate. In the example being discussed, the company’s cash need changed from $655,000 in 2018 to $4,625,000 in 2019 because of increased days sales outstanding in accounts receivable, coupled with shorter payable turn over.

Looking at the operating cycle over time and comparing the operating cycle to the line of credit structure and availability helps identify liquidity issues and changes. Preparing this same type of analysis by month is very helpful when considering the impact of seasonality on the cash needs of the business.

Why is this important today?

Because working capital account turnovers and balances are being impacted by supply chain disruptions and commodity price changes, previously acceptable levels of cash and line of credit availability may no longer work for a company.

The increased costs associated with inflationary pressures, labor issues, commodity prices, and supply chain disruptions are stressing financial performance. Companies that had an operating performance cushion in previous years may now be struggling to achieve break even performance. The operating performance shifts may be depleting the cash balances of companies. For example, if the inflationary, labor, commodity price and supply chain pressures have increased expenses faster than revenues are able to increase, a company’s cash balance will be depleted by the reduce operating and financial performance of the company.

The combination of impacts from the changes in the operating cycle on the line of credit structure and the impacts on operating performance from the economic pressures, may combine to eliminate any liquidity reserves a company had.

Expanding the annual analysis described above to a monthly analysis based on the 2022 forecast will help identify cash flow pinch points during typical business cycles within the year.

Next Steps

Moving into 2022 it will be imperative that the management of a company understands how its cash moves through the business – the operating cycle – and understands the impact of the economic pressures of inflation, commodity prices, labor, and supply chain issues on financial performance.

The availability of PPP loans and ERC credits helped companies survive the past two years but surviving 2022 is going to require more analysis and planning than before.

The excuses of inflation, commodity prices, labor and supply chain may be based on real financial impacts a business is experiencing, but the management of the company must turn those impacts into performance adjustments that ensure the health of the company in 2022.

The economic pressures are unprecedented in the past 20 to 30 years and will require creativity and an understanding of the financial impacts of decisions made related to customers, suppliers, and expense management.


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