How does a liquidity crisis come about and how can you solve it

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A liquidity crisis occurs when a company can no longer finance its current liabilities from its available cash.

A liquidity crisis can have many causes - sometimes self-inflicted, sometimes not. Here we show you how a liquidity crisis can arise, what the consequences are and how you can reduce the risk of such a crisis.

Liquidity crisis: Meaning for companies

A liquidity crisis occurs when a company can no longer finance its current liabilities from its available cash. For example, it is no longer able to pay its bills on time and therefore defaults on payments.

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In order to avoid insolvency, it must be able to obtain cash as quickly as possible in such a case. This is not always easy, which is why a company must ensure that it is as well prepared as possible for a liquidity crisis even in good times and that cash shortages do not occur in the first place.

Examples of a liquidity crisis

Example 1

A company has invested a lot of money in expanding its production because it assumed that customer demand would continue to increase. However, this is not the case: after some time, it realises that demand is decreasing for various reasons. Production is no longer being used to capacity and revenues are declining.

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Since it took out a bank loan to finance its investment, it now has to pay back monthly instalments, which is no longer possible given the falling income. It can therefore no longer finance its liabilities and a liquidity crisis arises.

In this example, the cause was a misjudgement of market development and customer demand. If the company had possibly carried out a more detailed market analysis, it would have realised that customer demand would fall and would have foregone the investment. The fault here therefore lies with the company because a wrong decision was obviously made that led to the liquidity crisis.

Example 2

Due to supply bottlenecks, delays occur time and again, as a result of which a company does not receive materials for production on time. The supply bottlenecks become tighter over time until the supplier can no longer supply the company with materials at all. After a few weeks, production in the company consequently comes to a standstill.

Although the company has a high demand, it cannot deliver its products now and so it misses out on revenue. On the other hand, it has to cover its running costs. For example, it still has to pay its employees, repay loan instalments and settle outstanding invoices.

Its cash reserves are depleted after three months and it can no longer meet its financial obligations due to the lack of income. A liquidity crisis arises. However, this is not the fault of the company, as it is not responsible for the supply shortage.

How to tell if there is a liquidity crisis or that there might be one?

As we have seen from the two examples above, a liquidity crisis can have very different causes. Sometimes it lies with the company itself, sometimes external events lead to it. To prevent companies from slipping into such a crisis so easily, they must always keep an eye on their liquidity.

Managers need to know at all times how high the cash flow and cash reserves are at the moment. In addition, they must have a reliable liquidity plan in which they can see how income and expenditure will develop in the coming months. This can show in advance whether a liquidity crisis is developing.

If, for example, you assume that customer demand will fall in the coming period, you take this into account in your planning with falling income. If you then look at the cash flow for these months, you can see whether you still have enough funds to cover your expenses.

Liquidity crisis: Solutions that help in the short and in the long run

To avoid a liquidity crisis in the first place, a company can take various precautionary measures that at least reduce the risk of a cash shortage.

Monitor accounts receivables

If you monitor your accounts receivable and manage them well, you reduce the risk of a cash shortage. By calculating various key figures such as Days Sales Outstanding, it is possible to assess how long it takes on average for a company to be paid by its customers.

If long invoicing periods often lead to cash shortages, these can easily be shortened so that a company receives its revenues more quickly and thus remains liquid.

With sound accounts receivable management, you no longer overlook overdue invoices, but can send a reminder as quickly as possible.

Smarter shopping and storage

If you buy a lot of goods or materials, you pay large sums for them. This pre-financing means that less cash is available to cover running costs. This can also lead to a liquidity crisis for some companies.

Companies that need a lot of goods or materials should therefore review their purchasing and storage strategy. It may make more sense to order fewer goods and to order them at shorter intervals so that less money has to be financed in advance. For some other companies, just-in-time procurement might also be an option, so that they can save on warehousing altogether.

Build up cash reserves

In times when business is good, it is advisable to set aside part of your income as cash reserves. We recommend that you have six months of cash reserves with which you can cover your running costs in the event of a complete business failure.

This gives you a large cushion to fall back on in case of an emergency, and you don't have to take out a bank loan straight away to meet your financial obligations.

Create cash flow planning

If you always keep an eye on your cash flow, you greatly reduce the risk of a liquidity crisis. In addition to the current cash flow, it also makes sense to draw up a cash flow plan. In this way, cash shortages can often be recognised before they arise.

This gives those responsible enough time to take measures to either completely avoid the cash shortage or at least mitigate its effects.

Furthermore, with detailed cash flow planning, investments can be better planned because you can see at what point in time you are likely to have enough cash available, or when it is cheapest to take out a loan. Those responsible make better decisions based on cash flow planning and actively counteract a liquidity crisis.

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