Hi << Test First Name >>,
Liquidity is a concept that is entrenched in finance. This doesn’t necessarily mean that it is properly understood, or that it doesn’t get misused all the time. This week, we are focusing in this mailer on the importance of understanding what liquidity really means and how it affects you.
Cash may be king, but liquidity is something different
Have you heard someone say “my business is really liquid” before? Usually, that person means that they have enough working capital in the business and cash flow isn’t a problem. That’s a lovely position to be in, but it suggests that liquidity speaks to the extent of a cash balance. Although that’s not miles off the truth (at least it speaks to the concept of cash), it’s not quite right.
You see, liquidity speaks to the efficiency with which an asset can be converted into cash without affecting its market price. The second part of the definition is so important and is ignored far too often. It’s accurate to say that a working capital cycle is liquid if sales turn into cash without major hassles around discounting or bad debts. It’s inaccurate to say that a business is liquid purely because there’s a pile of cash lying around. It’s the process that we are focusing on when we talk about liquidity, not the level of cash in the business.
Interesting - but how does this affect my valuation?
The conversion into cash without affecting the market price speaks directly to the relationship between the valuation of a business and how easily that business can be sold. The former is a theoretical construct based on an understanding of future cash flows and the risks attached to them. The latter is where the rubber hits the road. An illiquid business is going to really struggle to achieve the theoretical valuation.
Although a proper valuation takes liquidity discounts into account (and this is partly why private companies trade at lower multiples than listed companies in the same sector), there are further liquidity concepts that could make the business more or less liquid than average, which in turn would impact the valuation.
To identify some of these concepts, an exit readiness assessment is valuable. This focuses on some of the key reasons why a business could be illiquid, like dependence on the owner, or poor internal financial management processes.
If there are two private companies that are identical in all respects apart from owner dependence and availability of up-to-date financial information, a valuation conducted without the benefit of that knowledge would come out at the same number for both companies. In practice though, the business with owner dependence and questionable processes is far less liquid.
How does this play out in practice?
Typically, a buyer submits an indicative offer that is subject to due diligence. The due diligence process is where effort is put into identifying all the reasons why the company is (or isn’t) worth the indicative price. As issues emerge, the price inevitably comes down. This is because the company isn’t liquid, as it can’t be converted efficiently into cash without affecting the market price. Due to the internal challenges that weren’t identified and addressed timeously, the valuation and the offer price end up being far apart.
How do you avoid falling into this trap? There’s really only one way: prevention is better than cure. By doing an exit assessment as early as possible in your business journey, you’ll have a better sense of where the future liquidity constraints might be. When the time comes to sell, that makes all the difference.
And here’s the best part: even if you never sell the business, you’ll be running a much better business if you understand the drivers of value and liquidity.
Get started with this journey today by making use of a bizval valuation and/or exit assessment. You can dip your toes into the water with a free valuation or exit screening, or book a call with us to discuss your needs so that we can suggest the best route forward with our services. |
