Determining How Much Safety Capital You Have
Do you have enough safety capital? Are you prepared?
The last 2 years have seen balance sheet strength as an important business issue. Many banks (including the Lehman Brothers, Bear Sterns, etc.) failed due to liquidity issues. The issue of liquidity arose from a fundamental mismatch of the duration of assets and liabilities. Wikipedia defines liquidity as "the ability to meet obligations when they come due". This is different from solvency which is defined by Wikipedia as "the ability of a corporation to meet its long-term fixed expenses".
Liquidity can be measured using a number of financial ratios. Commonly it is measured using the current ratio (current assets / current liabilities). A more detailed view would look at the liquidity of specific assets in a business with the shortest duration assets being the most liquid against the most immediate creditor requirements. For example, cash is more liquid than accounts receivable. The following chart gives some examples of liquidity with estimated duration.
At the best of times matching the duration of assets and liabilities can be a difficult task because by their very nature, current assets and liabilities can fluctuate greatly. Corporations that have withstood the test of time employ a surplus of liquid assets which creates a safety margin for the business. How much safety capital is required depends on the certainty of your business liquidity and solvency measures. As part of each Company’s risk management strategy, the probability of the failure in any asset or acceleration of any liability and the severity of such a failure or acceleration should be assessed to determine the level of safety working capital that is needed to avoid potential liquidity shortfalls.
Examples of an asset failure include the failure of a customer to pay on time or at all or the loss of business equipment from an accident. Acceleration of liabilities could include things like legal judgements against the company, environmental liabilities and acceleration of debt. It should be noted that most Canadian term debt facilities are due upon demand of the bank at any time and as such if treated in accordance with Canadian GAAP and incoming IFRS may be classified as a current liability potentially adversely changing a Company’s current ratio tripping a banking covenant. Three to six months of excess working capital represents a good start from a safety capital perspective. This time frame varies with market conditions, but is usually sufficient to liquidate some assets (although perhaps at a loss to book value) or to seek refinancing or outside capital to recapitalize a business.
Fundamental mismatches between assets and liabilities can be dire for a Company without a strong balance sheet. The recent liquidity crisis and unprepared companies have shown that the consequences of such mismatches can be dire. Most of us have used a line of credit (personal or business) to buy a longer duration asset and are guilty of a mismatch.
Let us help you answer those key questions: Do you have enough safety capital? Are you prepared?