The Reasons for Declining Corporate Liquidity
Corporate liquidity is a measure of whether a company has enough cash flow to cover the cost of its operations and the payment of its bills. A company is said to be liquid if it has plenty of money to meet its expenses and illiquid if it doesn't. During slow selling seasons and periods of economic recession, companies customarily bolster their liquidity through short-term borrowings at their local banks.
During the period following the credit crisis of 2008, when banks were lending to only the highest-rated clients, many small businesses experienced difficulties in borrowing to finance their payrolls and inventory. Normally, tight credit conditions are the result of Federal Reserve tightening by raising interest rates, which makes it expensive for all but the very highest-rated borrowers. However, during the recession and slow recovery after 2008, interest rates were at record lows, making it difficult for banks to justify the risk of lending money to small companies that could be easily put out of business by the slow recovery or any further declines in the economy. Banks can afford to be less conservative in their lending standards when they are receiving high interest on their loans.
Companies manage their money in much the same way as do individuals. They save for large expenditures and to cover times when sales drop because of seasonal fluctuations or various types of crises. Company cash managers use money market instruments to maximize the return on their saved cash, but during periods of low interest rates, this return may not be sufficient to produce the additional money normally expected. This results in lower cash flow and reduced liquidity.
A company that sells ice cream might experience reduced sales during winter months, just as a company that sells down comforters might see its sales decline in the summer. Many companies experience revenue inflow as retail stores order extra inventory for back-to-school and holiday gift shopping. When these seasonal inflows of cash end, the company manages its cash to cover its operational, manufacturing and inventory expenses during the offseason. If there has been enough cash inflow, corporate liquidity remains strong, but if the selling season was disappointing, the company might become illiquid and forced to finance its operating expenses.
When incoming cash is not sufficient, or expenses arise such as unusual expenses owing to replacement of machinery or damage from a natural disaster, the company's liquidity is negatively affected. To remedy the cash flow shortfall, it seeks short-term financing to cover the deficit and restore liquidity. However, the success of this depends on whether banks are aggressively lending, and any reluctance on the part of banks to lend to companies facing liquidity problems results in forcing the company to lay off workers and suspend inventory accumulation. This has the effect of potentially reducing cash flow from future selling seasons if the company can't produce new products or sufficient inventory to meet buying demand, which also affects liquidity.