Liquidity is under-rated by SME entrepreneurs
The current weak economic scenario, as reflected in the recently released low IIP growth rates, is pushing several small and medium enterprises into a tight liquidity position. In contrast, several large corporates are sitting on huge cash balance – estimated at over Rs.4.5 trillion among the top 500 companies – providing them a strong shield to tide over a possible economic downturn. One key reason for this stark difference is the little importance that many SME entrepreneurs attach to maintaining healthy liquidity in good times. SMEs maintaining steady liquid cash balance, or undrawn bank limits, can face an economic downturn with a greater degree of confidence.
Poor liquidity can have serious ramifications
SMEs that attach low importance to maintaining healthy liquidity are particularly vulnerable during an economic downturn. Many of their large customers, be it FMCG companies or Auto majors or Retail conglomerates start stretching their credit period to SMEs during a downturn. At the same time, SMEs may have limited ability to stretch their payments to key suppliers such as steel or power or major commodities. The resulting tight liquidity position could threaten the very survival of the enterprise. Common problems of poor liquidity, such as delay in payment of salaries, defaulting on supplier payments or missing bank dues could seriously damage the reputation of the SME which takes long time to repair.
On the other hand, maintaining healthy liquidity has distinct advantages. Many suppliers offer significant cash discounts, especially during tight liquidity conditions. Availing such discounts through cheaper bank funding can help improve profitability of SMEs. Similarly, economic downturn could provide good acquisition opportunities that SMEs with healthy liquidity and financial strength can capitalize on.
Assets are not a substitute for liquidity
Many SME entrepreneurs have a penchant to buy real estate assets, funded out of their enterprise’s cash flows during boom times. While this definitely helps in creating long term wealth for the entrepreneur and the SME, it also wipes out the liquidity of the company and may force a distress situation at the sight of even a mild economic downturn. Long term assets like land, building and machinery cannot substitute for liquidity, which deserves specific attention of the entrepreneur on its own merit.
Treasury management is an unknown concept among SMEs. Even if there is no active treasury, maintaining basic liquidity needs certain fiscal discipline. Investing few month’s cash requirements in liquid mutual funds, or keeping certain percentage of the cash credit limits (and its drawing power) unutilised are common ways of maintaining health liquidity. SMEs should not worry about the low yield from the liquid assets or minimal commitment charges paid to banks for unused limits; this is the small price of insurance for protecting long term viability of the enterprise.
N. Muthuraman is Co-founder of RiverBridge Investment Advisors Pvt. Ltd., a boutique financial advisory firm and can be reached at firstname.lastname@example.org
This is the blog of the Print Version published in Business Line dated 14th Nov 2011