Sources of Liquidity Problems

There are many factors that lead to liquidity problems.

 

One of the factors, is overtrading, this problem usually occurs in small businesses which try to fund a large volume of production with insufficient working companies. This problem, however, is not only limited to small organizations larger organizations face this problem as well.

 

Another factor is investing too much in fixed assets; funds are usually limited in the early stages of a business and in this stage businesses tend to spend a great deal of money on equipment and other supplies can be detrimental to a businesses resources.

 

Stockpiling is another factor that could cause liquidity problems for a business; many firms buy in bulk to achieve economies of scale, however this is not always achieved and the discounts do not compensate for the extra cost of holding stock. Holding stocks is very expensive.

 

Another factor is allowing too much credit; many firms take advantage of the credit system as they do not have to pay for a particular good or service until a later date and delay payment as much as possible, this can cause problems for the other firm especially if they give the creditors a lot of time to pay them back. The worst case scenario is the firm would have to borrow money during this time because it has insufficient funds at that time.

 

On the other hand, taking too much credit can also cause a liquidity crisis; if the business takes too long to payback the credit that could then damage the firms reputation and effect firms future trades, it could also result in higher interest and lost discounts as the other firm may no longer willing to provide the firm with discounts because the payment has been delayed.

 

Business planning to expand may borrow large amounts in order to finance their expansion. This could result in overborrowing; the danger with overborrowing is that the firm could lose control to the bank or venture capitalist, for example. Successful business expansions are those funded by a balance of borrowed money and capital raised from share issues.

 

Businesses of underestimate inflation when calculating when planning future business decisions and it is also very difficult to predict the rate if inflation accurately as it always increases our expectations. With inflation comes higher interest, which puts pressure on a firm’s liquid resources.

 

Strikes, breakdown of equipment, bad debts and tax demands are all considered unforeseen expenditure which could cause a liquidity crisis. These events are unexpected.

 

Changes in consumer tastes and fashions, changes in demand in general can also cause a liquidity crisis. These changes can lead to an unexpected decrease or increase in demand. Businesses may not be able to compete with the increase in demand if that rises a great deal and they may suffer greatly from a sudden decrease in demand. 

 

Businesses need experienced financial managers to manage the finance of a business, poor financial management and bad decision making can cost the business a great deal.

 

Seasonal factors; some products or services are only popular during a certain time of year businesses with these products or services need to make sure that sale of their products and services can keep them going for another year.

 

How can a firm use credit control to improve their working capital position?

 

Having a tight credit control were the business is firm and strict about receiving the money that they own will help the businesses working capital position as the business will not have to borrow money in situations where they do not receive their money back. The presumed working capital is accurate. A tight and efficient credit control can avoid reduced profitability resulting from bad debts. The business can pay for day to day costs which are presumably small costs without having to reach out to other sources of finance. A tight credit control policy means that the firm will have a strong reputation, and other firms will be forced to pay payments on time. This policy will also help the firms capital in general because the firm will always having strong capital and when it comes to borrowing money as banks and venture capitalists will be more willing to provide them with finance. The firm will not have to delay any production or work , for example, because of insufficient funds in their working capital. A tight and strict credit control company may also provide the company with a competitive edge as other companies in the market might not adopt a tight credit control policy. 

Sources of Finance

Item:

 

1. An unexpected bill for repair of machinery. It must be paid immediately. The business has insufficient funds in it’s bank account.
2. 5 new delivery vehicles need to be purchased for the company.
3. A sports team needs new uniforms.
4. A new machine is required for a printing company.
5. A builder needs to buy materials for building a villa.
6. A new company is looking for start up capital.
7. A firm is looking to recover bad debts.
8. A salesman is paying for flights and accommodation for an overseas sales trip.

Answers: 

1. Short Term. Bank Overdraft because it is the quickest way to obtain money to pay for the bill and it is convenient and flexible. A bank loan would not be necessary in this situation because it is probably not a very large amount of money The business will then have to pay the business back with interest if its account is overdrawn.
2. The business could seek both a long term source of finance or a short term source of finance. If there is an increase in demand for the company than they can try to lease new trucks and pay for them regularly, this way they will be able to meet the increase in demand that they are facing. They can eventually purchase these trucks as leasing becomes very costly after a long period of time.    In terms of a long term source of finance, the business can try to raise share capital to purchase all 5 delivery trucks in the future.  A short term source of finance, leasing, is the more appropriate option for the business as they can start to utilize the trucks immediately and pay for it regularly, paying for it regularly means that they will not have to pay large sums of money at one time. The business can also benefit from not paying for any repair costs of the delivery trucks the firm that owns the trucks is responsible for these payments. The business will have to be careful and purchase the delivery trucks before leasing becomes too expensive. 
3. Short term.  The Trade credit system is probably the most appropriate in this situation, as the sports company will not have to pay for the uniforms immediately. The sports company will pay for the uniforms between 30-60 days later and not pay interest.  The sports company therefore could possibly utilize some of the profit from ticket sales for the different matches during the month to pay for the cost of the uniforms. 
4. Short term. Leasing would be appropriate in this situation because this new machine might only be required occasionally, the printing company would not have to pay large sums of money at one time. The printing company can test this machine over a short period of time and if the machine proves to useful and efficient and the business continues to need the machine they can purchase the machine before leasing for the machine becomes too expensive.
5. Short term. Trade Credit is appropriate in this situation because he/she would consistently need to purchase supplies, when unexpected problems occur or he might need to buy extra equipment that he did not think he needed at the beginning.  Using trade credit is much more suitable because the builder would not have to carry cash while he is working and that makes it convenient.  This system is useful for the firm that employs the builder as they will no exactly how much the materials that were needed cost and they do not have to pay for the materials immediately.
6. Long Term or short term. Share capital is the most appropriate long term external source of finance in this situation because it is very difficult for a new firm to raise capital immediately. They will have to raise share capital possibly from venture capitalists however, the disadvantage of venture capitalists is that they in effect become your boss and are involved in the business. A short term external source of finance could be a bank loan however banks are unlikely to provide new companies with large amounts of money as they are not as established as larger companies and are very risky. 
7. Short term. Bank overdraft is probably the most appropriate short term external source of finance to recover bad debts because the debts become the banks responsibility and the business can start from zero.
8. Short term.  A business credit card, i.e. the bank, would be an appropriate short term external source of finance because the cost of travel and accommodation for an overseas sales trip is a temporary, one off cost and is not as expensive as purchasing new delivery trucks, for example.