Financial setbacks can occur due to, for example, higher construction costs, inability to invoice due to IT problems, or production falling behind due to staff shortages. Savings, also called liquidity buffer, give you some time in such situations to take measures to resolve the incidents. If these temporary liquidity shortfalls cannot be compensated in time, this may translate into structural problems, deterioration of cash flow ratios, higher risk premiums on loans and, in the long term, perhaps even bankruptcy. A buffer therefore seems logical, but the design of a liquidity buffer is not that easy. After all, how is the amount and form of the buffer determined?

BUFFERING! (OR IS IT?)

Maintaining a liquidity buffer requires reserving available funds, but may be seen as unnecessary and socially undesirable. After all, there seems to be enough liquidity available to compensate setbacks and the public money could be better spent on social purposes. In practice, however, it happens that additional liquidity is not routinely or immediately available, or it is difficult to release funds quickly, or the additional liquidity is insufficient to temporarily compensate deficits.

Banks are also less likely to provide money to cover shortfalls during difficult times. In addition, the application process at a bank can take a relatively long time. To ensure the financial continuity of an institution in both good and bad times, many healthcare and educational institutions therefore feel the need to keep extra liquidity on hand, often encouraged by the accountant or the supervisory board. Next to that, bodies such as the WFZ (Guarantee Fund for the Health Care Sector), the Education Inspectorate and banks also stress the importance of a healthy liquidity buffer.

An important consideration is that the comfort of a liquidity buffer in the event of financial setbacks is only temporary. After all, you can only spend the money set aside once. If liquidity shortages continue and thus become structural in nature, you will have to look at long-term measures. However, using the liquidity buffer for structural deficits can give you more time to take a considered decision on the measures to be taken.

THE THICKER THE PIGGY BANK, THE BETTER?

An unequivocal answer to this question cannot be given. The starting points used differ per sector and per institution. In educational institutions, for example, we often see the current ratio as a yardstick for the buffer to be maintained. The current ratio indicates the relationship between the current assets and the current liabilities. The Education Inspectorate uses a current ratio of at least 0.5 for institutions in higher education and intermediate vocational education, and at least 0.75 for institutions in primary education, as a signaling value. However, many administrators and supervisory boards are comfortable with a higher standard and aim for a minimum ratio of 1.0 or higher.

An advantage of this methodology is that the current ratio does not yet take into account any room under the current account facility. This means that any current account facility can serve as an extra buffer in difficult times. A disadvantage is that the current ratio is generally a snapshot of the end of the year; no account is taken of intra-year developments. In case of an institution with volatile cash flows, guiding buffers by means of the current ratio can also lead to a yearly varying available buffer.

An alternative is to keep the amount of the liquidity buffer constant by steering towards an absolute norm. The WFZ, for example, advises healthcare institutions to use twice their turnover per month as the standard, but states that this is not a universal, objective standard. Zanders also sees many institutions using a standard of twice the monthly salary or 1.5 months' turnover. One point to note is that these standards are often quite high.

Our general advice is to gear the amount of the buffer to the liquidity development in both the short and long term, the risks and factors that play a role in your sector and in your institution. In addition, we recommend that the development of your long-term budget in the event of negative developments, also referred to as scenario analyses, be included in the consideration. Comfort can also play an important role. After all, it is up to you to determine which liquidity buffer is most appropriate and offers most comfort in daily operations.

DIFFERENT COMPONENTS OF YOUR BUFFER

Decisions must be made not only about the amount, but also about how to build up the liquidity buffer. Banks often offer the option of maintaining a liquidity buffer in the form of a current account facility, where the borrower pays commitment fees on the unused proportion and is charged a variable interest rate plus mark-up on the used portion. Generally, the amount of the current account is tailored to the institution's liquidity forecasts.

When deploying the current-account credit, it is important to determine whether it is committed or uncommitted. With an uncommitted overdraft, the bank can unilaterally cancel the facility daily - this is an availability risk. With a committed facility, there is the 'certainty' that the bank may not withdraw the facility during the agreed term. Also for this service, a commitment fee must be paid on the unused portion and the bank may ask for a higher mark-up during bad years when using the current account. In addition, there may be contractual terms that still allow the bank to unilaterally cancel the unused portion.

"An important consideration is that the comfort of a liquidity buffer in the event of financial setbacks is only temporary. After all, you can only spend the money set aside once."

From a risk perspective, it could therefore be argued that credit balances are safer than current account facilities. After all, this money cannot be cancelled unilaterally and there is no commitment fee on the unused portion or interest charges on the used portion. However, due to the low interest rates in recent years, the savings interest rate on credit balances has fallen to such a low level that it is currently even negative. For some banks this means that interest is no longer received on positive balances, but that from a certain size of credit balance onward, interest may have to be paid, also called negative interest. As a result, financing must then also be attracted in order to maintain the liquidity buffer, so there are double costs. In this case you not only pay interest on the credit balance, but also the regular financing costs.

Some institutions see their investment portfolio as an emergency pool they can use in difficult times. The advantage of invested money is that you do not suffer from negative interest rates or commitment fees. You also have a monthly stream of investment income. However, not every institution is allowed to invest money due to laws and regulations. Furthermore, you have to deal with counterparty risk, price risk in case of interim sales, and risk of negative returns. Moreover, the question is whether you can liquidate your investments fast enough to make payments.
The above options provide institutions with the room to have additional funds available during financially challenging times. However, the question remains as to which is the best option. Each option has advantages and disadvantages, and to make the choice even more difficult, a combination of the above options could also be a good solution for you.

CUSTOMIZATION, CUSTOMIZATION, CUSTOMIZATION...

Many institutions see the need to maintain a liquidity buffer either from a risk perspective, because of regulatory requirements, or for having comfort in operational execution. However, there is no simple answer to what the optimum level of a liquidity buffer is and how exactly it should be built. Each institution has its own risks and factors that must be taken into account. Setting up a liquidity buffer therefore requires a thorough analysis of cash flow development in the short and long term, key figures, costs, risks and options available from banks while adhering to legislation and regulations. In short, setting up a liquidity buffer is and remains custom work!

When a positive operating cash flow is realized, it is easier for a company to invest in acquisitions, fixed assets and innovation, for example. On the other hand, a negative operating cash flow can be an indication that the survival of an organization in the long term may be at risk. Therefore, a reliable cash flow forecast is of strategic importance for every organization and deserves attention at board level as well.
In one of our other articles about cash flow forecasting, we focus on information, processes and systems that are needed to come to an accurate cash flow forecast. In this article, we focus on the strategic side; which stakeholders, agreements and steering possibilities play a role to keep a grip on the cash flows in the long run?

STAKEHOLDERS

Having sufficient liquidity in the long run ultimately means continuity for the company. Internally, not only management (Board of Directors) but also the Supervisory Board (SB) is responsible for this. Large investments often have to be approved by both. They will therefore want to be informed well and in time about the expected development of the liquidity position in the short and longer term. After all, if a cash shortage threatens, directors' liability comes into play. The management board may not enter into any new obligations if it can reasonably assume that the current creditors cannot be paid (in the short term).
In some cases there may be a public shareholder. For them, insight into cash flows and the development of liquid assets is of great importance. After all, if a cash shortage is imminent, the shareholder is often the first to be approached to supplement this.
A company also has to deal with external stakeholders. The most important are often the financiers and the auditor. Financiers can be banks, but also ministries (through treasury banking) or care offices (funding). The financiers usually monitor the financial health of the company using various ratios and covenants. The liquidity position is very relevant here because, among other things, it gives an indication of the extent to which the organization is able to repay the outstanding loan(s).
Finally, the auditing external accountant follows the liquidity position with above-average interest, because when auditing the financial statements he must issue a continuity statement, among other things. This is only possible if there are sufficient liquid assets to meet current liabilities for at least 18 months in advance.

APPOINTMENTS

Internal agreements focus mainly on the frequency, timing and type of cash flow forecast. In calm, predictable times with an ample liquidity buffer the demands are different from those in uncertain, turbulent times. This therefore requires a different set-up of the organization. During predictable times and when there are no major investment plans, a good understanding of the liquidity position is still important, because it affects the amount of funding to be raised or the deployment of funds, for example.
However, in that case the frequency of forecasting does not have to be weekly, the timing is less strict and the indirect method suffices (in which the cash flows originate from the P&L account and the balance sheet. This method therefore also includes the cash effects of balance sheet changes). Reporting to management board members also takes place less frequently. However, if the company is in dire straits, this will not be sufficient and the frequency of the forecast and the reports will have to be increased. Moreover, the time horizon will be longer.

"In addition to making arrangements to make cash flows transparent, it is equally important to know what tools a director has to prevent a cash shortage."

The ability to attract additional funding is largely determined by the extent to which the organization is able to provide the necessary insight into, and correct substantiation of, the cash flows, assuming sufficient repayment capacity. This means that extra attention must be paid to the design of the processes, the mutual communication and the quality of the available data. Although these are matters that must be arranged in the operational process, this often does not happen automatically. It is therefore desirable for directors to keep a close eye and at least discuss the progress made in this area with the responsible manager(s).
It is also good for directors to be aware of the most important agreements in the financing contracts. For example: when must the (un)audited annual figures or the calculation of the bank covenants be submitted; what are the consequences of breaching the covenants; what conditions apply to obtaining a waiver? Although there is a whole process involved, it is good to realize that, worst case, failure to meet certain obligations in the contract can lead to an event of default and ultimately even a loan falling due.

CONTROL OPTIONS

In addition to making agreements to provide insight into cash flows, it is at least as important to know which instruments a director has to prevent a shortage of liquid assets. Before discussing this with financiers or possible shareholders, experience shows that they will often first demand that costs and revenues be closely scrutinized. Furthermore, outside the organization additional financing can be sought from banks or a ministry.
If available, a shareholder can be asked for additional capital. Which one should be approached first, again depends on the situation. In times of uncertainty, or when the financiers have financed a large amount (this can be determined using the net debt/EBITDA or Loan to Value), it is common to approach the potential shareholders first.
After all, because of the uncertainty about the future or the size of their current exposure, financiers will be reluctant to put extra money into the company. It is important to inform shareholders during good times and to keep them informed in the regular reporting cycle. To avoid being taken by surprise, they should be informed immediately of any development that could have a major impact. If the company is doing well and investments are needed to facilitate growth, for example, the financiers can be consulted first. Whether they are prepared to provide additional financing depends on several factors (such as the nature of the investment plans and the robustness of the forecasts provided), but the basic attitude will often be positive.

CONCLUSION

The importance of understanding the development of cash flows is not purely an operational matter. Cash flows play an important role in the continuity and flexibility of the business, the ability to invest, the timely identification of risks and the determination of the value of the business. For these reasons cash flows deserve attention at board level. To obtain good insights, the relationship with internal and external stakeholders, the agreements made with financiers and the measures to adjust play an important role. In all these matters, timeliness, predictability and accuracy are key to continuity and therefore important for a director. It is advisable to continuously invest in and pay attention to these issues.