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Importance of Liquidity

, October 30, 2012, 0 Comments

The current economic scenario, as reflected in the recently-released low IIP growth rates, is putting several small and medium enterprises in a tight liquidity position. In contrast, several large corporates are sitting on a huge cash balance — estimated at more than Rs 4.5 trillion among the top 500 companies — providing them a strong shield to endure 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.SERIOUS RAMIFICATIONSSMEs that attach low importance to maintaining healthy liquidity are particularly vulnerable during an economic downturn. Many big customers, be they FMCG companies, or auto or retail majors, start stretching their credit period during a downturn.Simultaneously, the 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. Problems of poor liquidity, delay in salaries, defaulting on supplier payments or missing bank dues could seriously damage the reputation of an SME.Maintaining healthy liquidity has its distinct advantages. Many suppliers offer significant cash discounts, especially during tight liquidity conditions. Availing such discounts through cheaper bank funding can help improve the profitability of SMEs.ASSETS, NOT A SUBSTITUTE

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 such as 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 a few month’s cash requirements in liquid mutual funds, or keeping a certain percentage of the cash credit limits (and its drawing power) underutilized are common ways of maintaining health liquidity.

The author runs a boutique SME advisory firm, RiverBridge Investment Advisors Pvt. Ltd. focussed on assisting SMEs in fund-raising and strategic investments. The author can be reached at