Managing liquidity

Financial Reporting Brief: January 2021

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Managing Liquidity - ‘Cash is King’

The call grows louder for a comprehensive corporate reporting structure – many say the ‘utopia’ of corporate stakeholders, who are looking forward to improved corporate reports and information. Developments will progress in the coming months and years and this series will return in future articles. For now, with financial reporting moving towards peak season, current frameworks must be applied to meet stakeholders’ expectations with reported information in which they can place their trust.

‘Cash is King’, an oft-quoted expression that has substance for all entities - meeting obligations, continuing activities, planning for future growth and having sufficient ‘headroom’ to cope with trading fluctuations and the unexpected. An entity’s liquidity must be carefully managed with regard to the management of current resources, the continuing availability of borrowings and other financing, and the ability to raise additional finance. In these challenging times, many entities are experiencing difficulties with liquidity. For some, this will bring into question their ability to continue as a going concern.

Previous articles have commented on the nigh-impossible task in these hugely uncertain times of forecasting on a reliable basis. Clearly explaining the base position and the estimates, assumptions and other information factors will help stakeholders to understand the reported information. These need to be continuously monitored and an approach adopted to forecasting which will adapt to change in underlying circumstances. In itself, the forecasting process will not provide a solution, but it may improve clarity. When done in a diligent and thorough manner it will concentrate minds, should help with an integrated thinking approach, and companies may well benefit from the process highlighting areas where constructive and/or remedial management action may be taken.

The importance of transparent and reliable information and disclosure cannot be overstated. Perhaps no question is more fundamental to stakeholders than - does the entity have the resources and ability to continue? A report has been published by the Financial Reporting Council in recent months ‘COVID-19 - Going concern, risk and viability’. The report considers each of these areas and highlights some of the key considerations for companies. The report also provides examples of current disclosure practices.

There have been many other publications providing guidance and insight in this and related areas.

Key questions for consideration are:

What are the critical questions a company must consider in managing its liquidity and preserving its ability to continue as a going concern?
How does a company ‘tells its own story’; with reliable presentation and disclosure that is transparent and understandable – with regard to both ‘front half’ narrative reporting and the financial statements?

Key Management Considerations

Key questions on liquidity management where investors are demanding answers, and examples of primary considerations, are:

How much cash does a company have?

Considerations: Location and access, potential barriers to access, possible implications with utilising, including taxation.

What cash and liquidity could a company obtain in the short-term?

Considerations: Availability of short-term financing arrangements and facilities, management of receivables and inventory, any additional support available from related businesses, shareholders, suppliers.

What can a company do to manage expenditure in the short-term?

Considerations: Dividend policy and plans, supplier financing schemes, capital expenditure commitments and flexibility, management of other commitments.

What other actions can a company take to ensure its viability?

Considerations: Government-backed support, stress testing of various scenarios, management of debt covenants and any similar factors, monitoring including Board strategy and direction.

How is a company protecting its key assets and value drivers?

Considerations: Plausible scenarios on cash management and forecasting, ability to change or modify strategy and business plan, short-term decisions with longer-term implications, customer service arrangements in changing trading conditions.

The above questions and considerations are likely to need to be tailored to a company’s own particular circumstances.

Disclosure Expectations

The pandemic underlines the importance of companies not just complying fully with the minimum reporting requirements but also considering whether additional information is required to satisfy the underlying reporting principles and objectives and to meet investor needs.

Key areas of disclosure include:

entity-specific forward-looking information which provides insights into the board’s assessment of business prospects, with underlying methodology and assumptions;
clear explanation of any material changes in the business model – and any related impact on the financial statements, including operating segments and cash generating units for impairment review purposes;
consistency of assumptions and judgements throughout the ‘front-end’ narrative reporting and the financial statements;
going concern disclosures, including significant judgements and assumptions, and appropriate narrative supporting the preparation of financial statements on a going concern basis; and
appropriate disclosure of information relevant to understanding the company’s financial risk management, particularly the potential impact of debt covenants on liquidity and the use of factoring and reverse factoring in working capital financing.

Liquidity – Need to Know

Investors and other stakeholders need to know what a company’s overall liquidity position is and what are the current challenges and future prospects.

An example of a key area in relation to liquidity is that many companies have financing arrangements which require them to comply with certain financial covenants in order to continue those arrangements which are likely to be key to the ability of a company to continue in operation as a going concern. In these challenging times, companies need to disclose details of covenants, even when they are in compliance and where there is significant ‘headroom’. Any judgements made in assessing compliance should also be explained.

Examples of areas in which disclosures may be particularly helpful in relation to covenants include:

The covenants, the underlying facility levels and the position at year end, preferably in tabular form;
Stress testing of how different forecast scenarios may impact on compliance with covenants;
How any new financing arrangements may impact on existing debt covenants;
Any waivers agreed with debt providers, or changes in covenant provisions; and
Potential impact of covenants on such matters as distributions and acquisitions.

From the early days of the pandemic, the majority of companies have disclosed key liquidity information such as availability of cash, undrawn borrowing facilities and compliance with covenants.

Examples of areas where many companies could improve their disclosures include supplier financing, covenant testing, and assumptions and judgements around going concern and viability.

Statement of Cash Flows

The statement of cash flows has featured in the top ten most frequently raised topics in the corporate reporting reviews carried out by the FRC in recent years. IAASA and others have expressed similar concerns.

A recently published report from the FRC based on a thematic review carried out has identified that while many companies complied with the requirements of IAS 7, there were areas where improvements could be made by many companies. These include:

Material inconsistencies between items in the cash flow statement and the notes;
Missing or incorrectly classified cash flows;
Inconsistencies between financing cash flows and the reconciliation of changes in liabilities arising from financing activities in the notes; and
Improvement in the disclosure of material accounting policies and significant judgements in relation to the cash flow statement, including the treatment of significant and large one-off transactions.

Some of the more frequently asked questions by the regulators in their review of cash flow statements, as part of the overall review process, included those in relation to investing activities, the definition of cash and cash equivalents, the reconciliation of profit to net cash flows from operating activities, the acquisition or disposal of subsidiaries, and incorrect classification of cash flows.

Conclusion

The availability of and the ability to access short-term cash resources is critical to building resilience and flexibility but, due to COVID-19 based disruption, they may ultimately be about survival. When business models are unable to operate for prolonged periods or are significantly restricted, the continuing existence of companies comes under severe scrutiny. In these circumstances, the management of resources and liquidity and the reporting on liquidity and going concern and underlying uncertainties becomes critical.

Investor expectations are robust – they understand and expect that for many companies COVID-19 creates significant issues. Quality disclosure helps them focus on those companies which need the most attention and support, and consequently enables their decision making processes.

Inadequate information will undermine the trust of investors and others.