Liquidity, Cash Flow and Capital
Liquidity, cash flow and capital play critical roles in ensuring firm solvency, especially during stress scenarios like the 2008 recession, and supporting the growth and performance of a firm. The three terms are often used interchangeably, but they are distinct and serve different purposes for firms. Firms have become insolvent because of inadequate capital, liquidity and/or cash flow, not only causing loss of shareholder value but also shaking confidence in the stability of the financial system.
Liquidity
Liquidity measures a firm’s ability to meet its obligations. These obligations can be met by using cash on hand, converting assets to cash, or accessing lines of credit. A firm’s liquidity refers to how quickly it can convert its mix of assets to cash or access other sources of funds to meet its obligations. During normal times, liquidity functions smoothly. But during periods of extreme stress, liquidity can dry up quickly and exacerbate an already tense situation.
The ability to liquidate assets to generate cash is very dependent on market conditions, and these conditions impact bid / ask spreads and liquidation time horizon.Lack of liquidity can cause a firm to fail even when it is technically solvent (assets being greater than liabilities). Liquidity is the life blood of financial services, and lack of liquidity can cause a run on any financial firm as clients seek to get their cash. Liquidity risk consists of both asset liquidity risk and funding liquidity risk. The Committee of European Banking Supervisors defines them as:
Asset Liquidity Risk: Also called market / product liquidity risk. It is the risk that a position cannot easily be unwound or offset at short notice without significantly influencing the market price, because of inadequate market depth or market disruption.
Funding Liquidity Risk: It is the current or prospective risk arising from an institution’s inability to meet its liabilities and obligations as they come due without incurring unacceptable losses.
Coming out of the 2008 recession, the Basel Committee agreed on a liquidity coverage ratio (LCR) and a net stable funding ration (NSFR). The LCR addresses a firm’s ability to maintain a liquidity buffer during a short-term stress scenario, while the NSFR addresses stable funding structures. In addition to these ratios, firms need to develop the ability to stress test liquidity in hypothetical scenarios and consider the various sources of liquidity and the risk posed by illiquidity.
While there is no single measure of liquidity risk, firms typically use a range of metrics to assess liquidity risk, and liquidity risk management usually starts with operational liquidity, which establishes the daily cash needs by forecasting all cash inflows versus outflows. Once operational liquidity is assessed, the next step is usually an analysis of a firm’s access to unsecured funding sources and the liquidity profile of its asset base. This information is integrated into a strategic perspective that looks at current assets, current liabilities, and off-balance sheet items.
A funding matrix is built that shows funding needs for various maturities. Any funding gap should be addressed by plans to raise additional liquidity through either borrowing or asset sales. A contingency funding plan establishes a plan of action should one of the liquidity stress scenarios develop. When a crisis hits, management usually has no time react, thus a pre-established plan is useful.
Liquidity risk has been a major factor in many crises impacting both credit risk and market risk. Cash and liquid assets provide a cushion that can be used to support funding needs.
Cash Flow
Cash flow refers to the amount of cash that flows into and out of a firms. Cash flow is typically associated with firms, but cash flow is also applicable to individuals and households. Whether it is a firm, individual or household, cash flow is critical because it is what’s needed to pay salaries, taxes, utilities, debt service payments and supplies - among other things. Insufficient cash flow generation typically leads to asset sales or increased liabilities (debt) to generate cash.
The Statement of Cash Flow provides a detailed picture of what happened to a firm’s cash during an accounting period. It details the sources and uses of cash and reconciles the beginning and ending cash balances. The Statement of Cash Flow is organized in three main sections:
Cash from Operating Activities: Operating Activities is the cash generated from core operating activities. It starts with Net Income and you add back non-cash charges like depreciation, and you look at various Balance Sheet and Income Statement accounts for changes from one period to the next.
Cash from Investing Activities: Investing Activities details where a firm chooses to invest or divest in assets.
Cash from Financing Activities: Financing Activities details where a firm either received financing or possibly paid down debt.
It is useful to think of cash flow in terms of sources and uses of cash.
Source of Cash
If an asset decreased due to a sale that would be a source of cash coming into the firm.
If a liability, such as a loan, increased you are getting to finance thus it is a source of cash.
If capital increased that is cash flowing into a firm from its owners thus it is a source of cash.
Uses of Cash
If an asset increased due to a purchase that would be a use of cash since cash is flowing out of the firm to pay for the asset increase.
If a liability, such as a loan, decreased you are paying down financing thus it is a use of cash.
If capital decreased that is cash flowing out of the firm to its owners, possibly dividends, thus it is a use of cash.
It is also important to recognize that cash flow and net income are not the same thing. Firms typically use accrual accounting, which requires an accounting entry when services are rendered, not when cash is received. This key difference is the reason why the Statement of Cash Flow was added to the selection of financial statements; in a sense the Statement of Cash Flow reverses accrual accounting and it shows the sources and uses of cash over an accounting period.
When evaluating a firm’s cash flow, investors need to consider their investment objective and consider the type of firm and the industry it is in. For example, a high growth bio-tech company will have very different cash flow from a mature firm that sells consumer staples. A high growth company would probably have lower Cash from Operating Activities and be more reliant on Cash from Financing Activities.
Capital
Capital is a financial cushion needed to absorb unexpected losses and support business growth. Expected loss is an estimate of losses a firm expects to incur and are considered a cost of doing business. Unexpected losses are those losses that exceed the amount of expected loss.
The best example of how expected loss and unexpected loss work is a loan portfolio. Based on the credit quality of a loan portfolio, a bank can estimate what its credit losses over a give time period. The bank would establish a loan loss reserve through a provision expense on the income statement, and the credit would reside as a contra-asset on the balance sheet. The loan loss reserve is the expected loss of the current portfolio. But in an extreme stress scenario, credit quality may deteriorate so quickly that capital is relied on as a buffer for unexpected loss.
Capital is also used to support the growth of a business. Capital on the balance sheet is the difference between assets and liabilities. Forms of capital also include economic capital and regulatory capital.
Economic capital is a measure of risk and distinct from regulatory capital, which is the amount of capital required by regulators. Economic capital is based on the probability of potential future losses. It is a forward-looking measure that is usually considered the difference between a given percentile of a loss distribution and the expected loss.
A fully developed economic capital model has the potential to better equip a firm to anticipate potential issues. The primary value of economic capital is its ability to influence decision making. Both economic capital and regulatory capital play critical roles in capital management, but the nature of economic capital makes it especially well suited for capital planning. Complimentary to the capital calculation is the incorporation of stress testing, where firms deploy forward looking stress tests that evaluate a firm’s ability to absorb losses and continue operations in a stress environment.
Summary
Regulators have increased their expectations for management to be pro-active in assessing the impacts of liquidity and capital during periods of extreme stress. The objective is to ensure that firms maintain solvency and that they can continue to play a critical role in the global economy. Investors can use a combination of ratio analysis and financial statement analysis to assess a firm’s liquidity, cash and capital, but it is equally important to take the time to read certain disclosures to attain a better understanding of practices as it pertains to these important topics.
References
Bank of England, “Bank Capital and Liquidity,” Quarterly Bulletin, September 17, 2013. Available at www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/2013/bank-capital-and-liquidity.pdf.
Basel Committee on Banking Supervision, “Basel III: The Liquidity Coverage Ratio and Liquidity Risk Monitoring Tools,” January 7, 2013. Available at www.bis.org/publ/bcbs238.htm.
Federal Deposit Insurance Corporation , “Supervisory Insights; Economic Capital and the Assessment of Capital Adequacy.” Available at www.fdic.gov/regulations/examinations/supervisory/insights/siwin04/economic_capital.html.