The liquidity crisis is a concurrent increase in liquidity requirement and reduction in liquidity availability across a wide range of financial entities and other businesses. Widespread maturity mismatches across banks and other enterprises are the base causes of a liquidity crisis, resulting in a scarcity of cash as well as other liquid assets when they are needed.

Large negative economic shocks or typical cyclical fluctuations in the economy can both generate liquidity crises. When a firm faces a liquidity shortage and can't remedy the situation by selling enough assets to cover its obligations, the company must declare bankruptcy.

Causes of liquidity crisis in banks include major solvency or liquidity issues, either as a result of a common external shock or as a result of failure in one bank or a group of banks spreading to other banks in the system. A systemic banking crisis occurs when a country's financial and business sectors have a high number of defaults and financial institutions and companies have significant difficulty fulfilling contracts on time. As a result, non-performing loans skyrocket, and all or almost all of the financial system's capital is depleted. This may even become a cause of the global liquidity crisis.

Funding for small, medium and big firms is available during periods of economic development and prosperity. The circumstances under which firms access capital and liquidity eases, leverage ratios improve, interest rates reduce, reporting requirements lessen, and covenants and lender safeguards rapidly fade away. These circumstances provide business owners the freedom to do anything like pay debts, make a long-awaited acquisition, issue a dividend, or buy out an aged or inactive partner.

During times of economic crisis, however, this process can quickly reverse itself. As cash flow generation drops and debt levels stay constant, leverage ratios automatically rise. Instead of supplying additional financing, capital sources tend to tighten terms. The issues that owners are confronted with begin to shift. 

While there is no precise roadmap for managing liquidity during a crisis, there are a number of tried-and-true concepts that can assist company owners through this moment of uncertainty.

Measuring Your Liquidity

The current ratio, or the ratio of current assets to current liabilities, is the most popular technique to assess liquidity. The current ratio assesses your capacity to convert current assets to cash (including cash and cash equivalents, securities, inventories on hand, and accounts receivable). Generally, the higher the ratio, the more liquidity you have.

One issue in such ratios is that cash conversion cycles slow down during times of economic crisis, making quick assets less quick, receivables take longer to collect, and inventory sells more slowly. It's a good idea to break down balance sheet categories and figure out how quickly and for how much value each asset may be converted to cash. Using your investment adviser to set up a line of credit might assist you to avoid selling long-term investments at the worst possible time. Assume late payments on accounts receivable and fading demand and price cuts for inventories when evaluating current assets. Assume you'll need to sell items at a deficit to free up cash.

Liquidity Forecasting

The best-managed firms will model liquidity crunch scenarios on a regular basis. The purpose of this financial modeling exercise is to predict a decrease in cash revenues when the demand for cash resources increases. Businesses would frequently prioritize liquidity above profitability in times of distress. In the near term, your capacity to perform with your suppliers and customers is a function of liquidity, and it will likely give commercial chances that will position you for growth once the stress has faded.

Managing Debt and Liquidity

Asset-based or borrowing-based liquidity models automatically restrict available liquidity. Due to decreased EBITDA, companies borrowing on cash multiples (for example, debt/EBITDA) may be on the verge of violating covenants. If you plan to breach covenants or have concerns with qualifying collateral, you should notify your lender as soon as possible. If lenders are aware of problems before they emerge, they are more likely to be receptive.

The crisis may have an impact on lenders' liquidity profiles, which will have an impact on their borrowers. The number of defaults in portfolios of direct lending funds may be increasing, limiting their access to the bank cash they need to fund loans. Funding costs may be on the rise, particularly for lenders that lack a natural deposit base. It's vital to understand how your lender finances itself.

Strategic Approach

The essence of every firm is liquidity. Understanding, evaluating, and projecting your liquidity situation is critical for surviving economic downturns and ensuring your organization thrives when conditions recover. There are several tools available to business entrepreneurs. Consider disposing goods to increase liquidity, even if it means sacrificing short-term profits. Develop a communication strategy with all of your stakeholders, and if required, negotiate longer payment terms with your vendors. Your liquidity situation is strongly influenced by how you handle each stakeholder. Businesses with a solid cash position will be able to withstand the storm. When the light shines again, those who manage it well will have the finest opportunity to flourish anew.