RBC Business Insights

Liquid measurements:
Are you planning for your
cash needs?

Contents

Sales and Profits Aren’t Enough 2

What’s a Liquid Asset? 2
Covering Shortfalls 3
Make the Most of Cash on Hand 4
Liquidity Checklist 5

RBC Royal Bank

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RBC Royal Bank Liquid measurements: Are you planning for your cash needs? 2

Liquidity and Cash Flow:

The Foundations
of Business Success
Sales and Profits Aren’t Enough
A strong cash Increasing sales, expanding your market and generating strong revenues and profit margins –
position will not all are signs of a healthy business. But that’s not enough. Businesses need access to cash to pay
only help ensure vendors, cover payroll, buy supplies, service debt, and meet other financial obligations. It’s
called liquidity – the ability to produce a flow of cash to pay the bills until customers pay you.
the long-term
viability of the In today’s economy, liquidity is more important than ever, says the Conference Board of Canada:
organization, it “A strong cash position will not only help ensure the long-term viability of the organization, it
will provide the platform for strategic acquisitions and future growth.” In a survey* about busi-
will provide the ness risks, conducted across 40 countries and 30 industries, respondents noted that "cash flow
platform for and liquidity" was a striking concern alongside the expected items such as "regulatory changes",
"increasing competition" and “business interruption".
strategic acquisi-
tions and future Many companies which have experienced problems, can trace their difficulties to a poor frame-
growth. work for managing and planning liquidity needs. Quite simply, effective cash management is a
foundation of a thriving company. Without it, chances are your business will struggle. With it,
you optimize your opportunities for success.

What’s a Liquid Asset?

Liquid assets are those that can be converted to cash quickly, with little impact to the price
received for the asset. They are essentially regarded as cash because: 1) their prices are relatively
stable when they’re sold (there’s an established market with enough participants to absorb the sale
without materially impacting price); and 2) it’s simple to transfer ownership and move the asset.

Some assets are highly liquid and have low liquidity risk (such as most stocks, money market
instruments and government bonds). Other assets are illiquid and have high liquidity risk (such
as single purpose industrial buildings).

Liquidity risk is the risk that arises from the difficulty of selling an investment or asset. It’s
important to take inventory of your assets and ensure you have enough liquidity to make your
necessary payments if you face unexpected delays in incoming cash.

* AON Global Risk Management Survey, 2009

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RBC Royal Bank Liquid measurements: Are you planning for your cash needs? 3

Covering Shortfalls
Managing cash flow is a matter of maximizing cash in and controlling cash out. That includes
everything from issuing invoices promptly, to using electronic payments, to relying on your
bank’s cash management services.

Sometimes, no matter how well you manage your cash flow, things can still go wrong – a major
customer delays payment, or an asset needed for day-to-day operations malfunctions and halts
production. Liquidity is the ability to have access to cash to pay the bills until your customers
actually pay you. You need to know the best ways to cover liquidity shortfalls.

One of the best ways to prepare for these unanticipated events is to have access to cash through
credit. Every company’s approach to debt can differ. In uncertain economic times, companies
may try to reduce their reliance on debt. But the bottom line is that you may need debt to keep
the lights on and ensure everyone gets paid.

Don’t be afraid to borrow to cover a shortfall – provided that it truly is a shortfall and not something
more systemic that requires other corrective strategies. Borrowing can be a cost-effective
method to keep cash flow on an even keel. Here are three strategies to cover shortfalls, in order
Don’t be afraid of preference.

to borrow to cover 1. Revolving line of credit

a shortfall,
› How it works: When your bank, operating or current account balance falls below a certain
provided it truly threshold, funds go into the bank account from the line of credit.
is a shortfall, and › Should you use it: A revolving line of credit optimizes borrowing – you don’t have too much
not something or too little in your current account, and you don’t have excessive amounts owing on your
line of credit accumulating interest. The unused portion of your credit line is where you can
more systemic.
obtain significant liquidity. Remember too that suppliers might offer a discount if you pay
early, so you can tap into your revolving line of credit to take advantage of such deals (suppliers
could also extend extra time to pay; see #2).

2. Vendor / Supplier credit

› How it works: A supplier grants you 30 days or longer to make your payment.

› Should you use it: You can benefit from the willingness of suppliers to provide credit, and
might want to choose a mix of vendor/supplier credit and a revolving line of credit to handle
shortfalls. The downside: suppliers can get nervous when you ask to change the terms of
payment, and late payments can hamper both your credit rating and your relationship with
your supplier. If you lose trade credit, it can also have negative implications on your future
cash flow, and you may have to pay cash on delivery or in advance.

3. Asset-based financing

› How it works: A form of working capital that’s secured by assets like accounts receivables,
inventory, and sometimes machinery and equipment.

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RBC Royal Bank Liquid measurements: Are you planning for your cash needs? 4

› Should you use it: This form of financing is ideal for companies at certain transition points, such
as: starting up, fast growing, merger or acquisition, refinancing existing debt, or management
buy-outs. Yet it’s usually a more expensive option, so would usually be used in situations
where a revolving line of credit might be unavailable or is insufficient (e.g. you’re profitable,
but have a high percentage of debt relative to your receivables).

With cashable and Other financing options exist, and your lender can discuss what’s right for you. Keep in mind that
cash management comes into play here another way; how much lenders will advance you may
non-cashable depend upon how skilled you are at managing your cash and planning for contingencies.
GICs, you trade off
liquidity to get a
Make the Most of Cash on Hand
higher rate. Just as businesses can go through periods when spending outpaces payments from customers,
there can be other times when you have cash on hand. You’re likely to need the money later in the
business cycle when expenses rise. In the meantime, what are the best instruments to increase the
earning power of your surplus cash, while ensuring you can use that cash if you need it?

1. Interest-paying accounts
Most banks have interest-paying accounts, which allow you to access funds whenever needed. For
companies that maintain higher balances in their accounts, customized interest arrangements can
be negotiated that take into consideration a company's cash flow, while continuing to provide high
liquidity. Generally, this is available to companies holding $100,000 or more in average balances.

2. GICs
For slightly higher rates, look for GICs (Guaranteed Investment Certificates) or term deposits.
The terms can vary, generally from 30 days to 5 years, and either fixed or floating interest structures.
Often, the best solution for a company is to structure a GIC based on its cash forecasts, and
subject to its need for contingency funds. For example, a company that doesn’t anticipate needing
$100,000 for the next 90 days might put $80,000 into a 90-day fixed rate closed GIC, and keep
$20,000 in a cashable GIC for the same term.

Both interest-paying accounts and GICs are insured by CDIC (Canadian Deposit Insurance
Corporation) to a maximum of $100,000. (Most Canadian chartered banks are CDIC members,
as are Canadian loan and trust companies and associations governed by the Cooperative Credit
Associations Act, all of which take deposits.)

Besides these two options, there are other short-term options in which to invest your cash, such as:

› Treasury bills, which are uninsured and usually require a $100,000 minimum. These will fluctuate
in value if not held to maturity.

› Mutual Funds are also uninsured and you will likely have to move the funds to your personal name.

Remember, your surplus cash is your security blanket. In general, you have to balance your
desire for returns with your need for liquidity. With interest-paying accounts, for instance, rates
aren’t as high as with GICs, but you get liquidity and convenience. With cashable and non-cashable
GICs, you trade off liquidity to get a higher rate. Talk to your banker about the investment options
that make the most sense for your business.

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RBC Royal Bank Liquid measurements: Are you planning for your cash needs? 5

Liquidity Checklist
Does your business have proper liquidity governance? The more you prepare for shortfalls,
contemplate worst case scenarios, and borrow or invest prudently, the better able you are to
ensure a steady, secure cash flow. Consider these key questions:

› Do you know when will your sales turn into cash?

› Can you control your expenditures to mirror your cash inflow?

› Have you identified peak income periods and slowdowns?

› Are you prepared to face possible cash shortfalls?

› Do you have a robust and operational contingency funding plan? Where will you get your
money from as a secondary line of defence, beyond your line of credit, if required?

› Are you maintaining an adequate level of liquidity, with room in your operating line of credit
or liquid investments?

› Have you designed and used severe stress test scenarios? What would happen, for example, if
sales dropped 20%? How long could you hold out before you had to let staff go or cut back in
other undesirable ways?

› When investing your cash on hand, do you know your liquidity risk tolerance to determine
acceptable return on investments?

› How much access to cash do you need to feel comfortable?

› Have you identified and measured the full range of liquidity risks? (The risk that a given security
or asset can’t be traded quickly enough to prevent a loss or make the required return.)

The more you prepare for shortfalls, contemplate worst case scenarios, and borrow or invest
prudently, the better able you will be to ensure a steady, secure cash flow. There’s a lot to think
about, and your accounting professional and financial institution can offer you advice. With a little
foresight and some smart decisions about liquidity, you can put your business in the best position
to succeed through all cash cycles.

RBC Royal Bank

The content of this publication is provided for informational purposes only and is not intended to provide specific advice on your business
operations and investments and should not be relied upon in that regard. Not all methods described herein will be appropriate in all cases.
Before implementing any strategy you should speak to an expert about your particular business and create a plan which is designed to
suit your requirements.

® Registered trademarks of Royal Bank of Canada. RBC and Royal Bank are registered trademarks of Royal Bank of Canada.

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