Managing Liquidity Risk with Outsourcing Suppliers
by Hilary Weatherstone, Director, Lloyds TSB Corporate Markets
Although the liquidity crisis has been rumbling on in the banking sector for almost 18 months, the collapse of Lehmans in September has pushed the crisis into the real economy. This event marked a profound transformation of the financial sector, and every government, bank, corporation and individual is now seeing the impact. What is also apparent is the phenomenal speed with which the downturn has taken place: since the summer, when it was largely “business as usual” for companies outside the banking sector, companies of all types are now experiencing a significant fall in revenues. With economic change accelerating, and such a rapid and substantial alteration in companies’ liquidity profile, the focus for all firms must be to create working capital and preserve liquidity. However, this focus extends beyond the company’s own finances to its supply-chain. Many firms are dependent on their outsourcing suppliers for business-critical services/infrastructure. This is often paid-for upfront by the supplier and repaid incrementally by the company, creating substantial risk to that company should the supplier collapse. As a result, a firm that experiences a critical supplier failure would need to soak up any overhang cost or replacement cost of the service – draining liquidity from the balance sheet.
Approaches to the Crisis
The demand for liquidity far outweighs its supply in the current market, driven primarily by a significant deterioration in the confidence of market participants. In fact, sources of liquidity, which companies previously took for granted, are disappearing or the pricing has increased dramatically (margins have moved by a factor of up to 10 times in some cases) making them prohibitive. With declining revenues and fragile financing, companies are approaching the crisis in different ways. Mature, seasoned companies, which have weathered downturns before, have placed professionals with substantial financial expertise at the helm of their business. These companies recognise the importance of sourcing adequate liquidity to cover difficult times, despite the high costs of doing so. While these firms may experience lean times ahead, they will ultimately survive.
However, not all companies have the experience or expertise in-house to appreciate the importance of shoring up the company’s finances or to recognise how to go about doing so. This is particularly the case for lower rated companies, or those which have grown quickly during the benign economic period of the past ten years. In these cases, many senior executives will not be equipped to keep up with the pace of change in the deteriorating economy. Even though the cost of borrowing may be high today, securing financing when a company’s liquidity has dried up and performance is poor is likely to be impossible. In many cases, executives of these companies may believe that they are acting prudently by maintaining the debt burden at pre-crisis levels, but in reality, a “wait and see” approach is likely to prove fatal.