Published on 6 May 2011 by Tony Groom

There is some doubt about whether small businesses in particular understand the concept of liquidity.

When borrowing against assets, such as the sales ledger using factoring or invoice discounting or plant and machinery finance or property mortgages, there seems to be a widespread misunderstanding among businesses about business funding and, in particular, the obligations to secured and asset based lenders.

While credit is the most common form of finance generally, certainly among smaller trading businesses, there are many other sources of finance and lots of ways to generate working capital. Working capital however is different to purchasing property or capital equipment. The finance required by different industries and by businesses in different situations should be tailored to their specific needs, he says. All too often the wrong funding model results in the business quickly becoming insolvent with the prospect of failure or at least some degree of painful restructuring. In spite of this, borrowing against the book debts unlike funding a property purchase is a form of working capital.

When a company is growing it requires additional working capital to fund growth. When a company is stable, where sales are not growing, then it can be argued that current assets should be the same as current liabilities, which is often achieved by giving and taking similar credit terms.

When a company is in decline its future income will be reducing and this should be offset by a reducing need for working capital. The real problems arise when liabilities are stretched and the reducing income means that creditors are stretched even further. This tends to occur when companies rely too heavily on sales ledger finance.

Understanding liquidity and the various liquidity ratios is crucial he says. Although the ‘current ratio’ which is based on current assets divided by current liabilities is used by some, a more accurate measure of liquidity is the ‘quick ratio’. This removes from the calculation stock which cannot always be easily converted into cash.

When current assets excluding stock equal current liabilities the quick ratio is “1”. This is calculated by dividing current assets minus stock by current liabilities. When the Quick ratio is greater than “1” the surplus assets provide a financial cushion to help a business survive any short term problems. However when the quick ratio is much less than “1”, a company’s scope for survival is considerably reduced.

Significant borrowings, whether via book debt finance, overdraft or callable loans, add up to a large current liabilities figure. This renders a business vulnerable to losing control to its secured lenders. Also known as the ‘acid test’, the quick ratio is a financial indicator of how vulnerable a business really is. “Why is it so rarely monitored by businesses?” says Groom.

Restructuring a business offers the opportunity of changing both the operating model as well as the financial model to achieve a funding structure that is appropriate to support the strategy, whether growth, stability or decline. Dealing with liabilities, whether by refinancing them over a longer period or converting debt to equity or writing them off via a Company Voluntary Arrangement (CVA), can significantly improve liquidity as measured by the current and quick ratios.

Borrowing against the sales ledger is an entirely appropriate form of funding for a company that is growing. However, he believes it is not right for a company in decline and the overall risk must be measured by reference to appropriate ratios.

In spite of all this, factoring or invoice discounting, like credit, are brilliant ways of funding growth by providing working capital.