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RBC Business Insights

Liquid measurements: Are you planning for yourcash needs?

Contents

Sales and Profits Arent Enough 2

Whats a Liquid Asset? 2

Covering Shortfalls 3

Make the Most of Cash on Hand 4

Liquidity Checklist 5

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Liquidity and Cash Flow:The Foundationsof Business SuccessSales and Profits Arent EnoughIncreasing sales, expanding your market and generating strong revenues and profit margins all are signs of a healthy business. But thats not enough. Businesses need access to cash to pay vendors, cover payroll, buy supplies, service debt, and meet other financial obligations. Its

called liquidity the ability to produce a flow of cash to pay the bills until customers pay you.

In todays economy, liquidity is more important than ever, says the Conference Board of Canada: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-ness risks, conducted across 40 countries and 30 industries, respondents noted that "cash flow and liquidity" was a striking concern alongside the expected items such as "regulatory changes","increasing competition" and business interruption".

Many companies which have experienced problems, can trace their difficulties to a poor frame- 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.

Whats a Liquid Asset?Liquid assets are those that can be converted to cash quickly, with little impact to the pricereceived for the asset. They are essentially regarded as cash because: 1) their prices are relatively stable when theyre sold (theres an established market with enough participants to absorb the sale without materially impacting price); and 2) its 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 (suchas single purpose industrial buildings).

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

* AON Global Risk Management Survey , 2009

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

A strong cashposition will notonly help ensure

the long-termviability of theorganization, itwill provide theplatform forstrategic acquisi-tions and futuregrowth.


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Covering ShortfallsManaging cash flow is a matter of maximizing cash in and controlling cash out. That includeseverything from issuing invoices promptly, to using electronic payments, to relying on yourbanks cash management services.

Sometimes, no matter how well you manage your cash flow, things can still go wrong a majorcustomer delays payment, or an asset needed for day-to-day operations malfunctions and haltsproduction. Liquidity is the ability to have access to cash to pay the bills until your customersactually 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 throughcredit. Every companys approach to debt can differ. In uncertain economic times, companiesmay try to reduce their reliance on debt. But the bottom line is that you may need debt to keepthe lights on and ensure everyone gets paid.

Dont 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-effectivemethod to keep cash flow on an even keel. Here are three strategies to cover shortfalls, in orderof preference.

1. Revolving line of credit

How it works: When your bank, operating or current account balance falls below a certainthreshold, funds go into the bank account from the line of credit.

Should you use it: A revolving line of credit optimizes borrowing you dont have too muchor too little in your current account, and you dont have excessive amounts owing on yourline of credit accumulating interest. The unused portion of your credit line is where you can

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 (supplierscould 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, andmight want to choose a mix of vendor/supplier credit and a revolving line of credit to handleshortfalls. 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 futurecash 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 thats secured by assets like accounts receivables,inventory, and sometimes machinery and equipment.



Dont be afraidto borrow to covera shortfall,provided it trulyis a shortfall, andnot somethingmore systemic.


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Should you use it: This form of financing is ideal for companies at certain transition points, suchas: starting up, fast growing, merger or acquisition, refinancing existing debt, or managementbuy-outs. Yet its 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. youre profitable,but have a high percentage of debt relative to your receivables).

Other financing options exist, and your lender can discuss whats right for you. Keep in mind thatcash management comes into play here another way; how much lenders will advance you may depend upon how skilled you are at managing your cash and planning for contingencies.

Make the Most of Cash on HandJust as businesses can go through periods when spending outpaces payments from customers,there can be other times when you have cash on hand. Youre likely to need the money later in thebusiness cycle when expenses rise. In the meantime, what are the best instruments to increase theearning power of your surplus cash, while ensuring you can use that cash if you need it?

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

2. GICsFor 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 doesnt 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 InsuranceCorporation) 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 fluctuatein 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 yourdesire for returns with your need for liquidity. With interest-paying accounts, for instance, ratesarent as high as with GICs, but you get liquidity and convenience. With cashable and non-cashableGICs, you trade off liquidity to get a higher rate. Talk to your banker about the investment optionsthat make the most sense for your business.



With cashable andnon-cashableGICs, you trade off liquidity to get ahigher rate.


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Liquidity ChecklistDoes 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 toensure 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 yourmoney 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 creditor 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 inother undesirable ways?

When investing your cash on hand, do you know your liquidity risk tolerance to determineacceptable 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 cant 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. Theres a lot to think about, and your accounting professional and financial institution can offer you advice. With a littleforesight and some smart decisions about liquidity, you can put your business in the best positionto succeed through all cash cycles.


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The content of this publication is provided for informational purposes only and is not intended to provide specific advice on your businessoperations 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 tosuit 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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