This research proposal studies on the liquidity risk of the manufacturing companies. The complete liquidity ratios analysis are used can help uncover weaknesses in the financial position of companies. The theoretical framework such as cash flow forecasting, financial ratio analysis, and assessment of funding facilities will used to measuring liquidity risk of the manufacturing companies.
1.1 Objectives:
1.) To investigate the methods of measuring liquidity risk of the food manufacturing companies.
2.) To investigate the way to manage liquidity risk of the food manufacturing company.
3.) To analyze the financial characteristic among food manufacturing companies.
1.2 Research question:
1.) What are the methods in measuring liquidity risk of the food manufacturing companies?
2.) What methods to manage liquidity risk of the food manufacturing companies?
3.) What are the financial characteristics that affect liquidity risk among food manufacturing companies?
2.0 Introduction:
Liquidity risk is the risk that an industry will have inadequate funds to meet its financial commitments in a timely manner. The two elements of liquidity risk are short term cash flow risk and long term funding risk. The long term funding risk includes the risk that loans may not be available when the industry requires industry or that such fund will not be available for the required term or at acceptable cost. Nowadays, liquidity risk it’s not just for banks. While many businesses would now be very well-known with cash flow risk, awareness of long-term funding risks is also important. An inability to manage either component of liquidity risk may heighten the chances of the industry becoming insolvent (Accountants today, 2010). This is including manufacturing companies as well.
However, liquidity is dynamic and can change according to both industry and marketplace conditions. They will give rise to the need to ensure adequate liquidity to cover all events. The sources of liquidity risk include seasonal fluctuations, unplanned reduction in revenue, business disruption, unplanned capital expenditure, maturing of financing facilities, and inadequate or non-existent financing facilities.
Liquidity risk is the recent and potential risk to earnings or capital arising from a bank is inability to gather its obligations if they appear due without incurring unacceptable losses. Liquidity risk includes the incapacity to manage unplanned decreases or changes in funding sources. Liquidity risks also arise from the collapse to recognize or address changes in market conditions that affect the ability to liquidate assets rapidly and with smallest loss in value (Tiwari, 2009).
Significance of study:
Basically, this study aims to finding out the liquidity risk of the manufacturing companies and help in investigates to manage liquidity risk in manufacturing company. The study would also contribute to the more understanding of the financial performance of the manufacturing company. Based on some accountants magazine, where a manufacturing business has sufficient liquidity, there is also the opportunity of improved profitability through reduced interest expense or increased interest income (CPA, 2010). Besides that, the manufacturing company together with better financial elasticity to negotiate improved terms with suppliers and financiers or particular in new business opportunities.
Literature review:
According to article contributed by CPA Australia (2010), there were three methods used to measure liquidity risk such as cash flow forecasting, financial ratio analysis and assessment of funding facilities in manufacturing company. The cash flow forecast will enable to ensure have sufficient cash flow before take on any financial commitment, identify any potential cash shortfall and to see when the problem occur and sort them out in advance. For example, if the company has large daily cash flow volume transaction, then daily cash flow forecasting is may be best suited (CPA, 2010). Net cash flows must to appear at future calculate on a day-by-day that is a simple test for liquidity risk. This has a concern negative on any day. Stress testing such an analysis can be supplement with net cash flows on a day-to-day appear based on statement that an important counterparty defaults (Anthony, 2009). Furthermore, method that measure liquidity risks were financial ratio analysis can be used to identify key areas of industry liquidity risk. There were indicators of operating cash flow, liquidity ratio and financial strength. These indicators also used interest expense of short term ability to service debt and the ratio of debt to gross cash flow to measure liquidity risk of industry. Liquidity ratios were measure that indicates an industry is ability to repay short term debt and gauge a firm liquidity. Which may be useful in assessing liquidity include quick ratio, current ratio, and percentage of current liabilities. Using these ratios was important to reflect on the value for both stock and debtors of the industry (Chandra, 2003). For example, if the industry has a large amount of unsalable stock or uncollectable debtor’s funds, then the ratios may need to use adjusted figures to return this (CPA, 2010). Besides that, financial strength were appropriate ratio of debt to equity will depend on the type of industry and the nature of operations and revenue quality consistency and reliability was a critical factor in determining an appropriate level of gearing. At the same time, method that assessment of funding facilities include the extent the industry relies on financial facilities, extent the industry relies on only one lender, availability of funds in extreme crisis conditions and status of financial facilities committed or uncommitted. There were the key areas to assess the liquidity risk of the manufacturing companies.
If the food industry drop within minimization of transactions costs, production smoothing and stock out risk (blinder and Maccini, 1991). Food industry may change from one types of produce to another producing and finished product. The industry may hold cash if the cash necessary to payments and fixed transactions cost must be incurred when liquidating other assets (Tsiang, 1969). If goods or cash are independently distributed overtime, it is optimal for industry facing fixed transactions costs to reorder inventories (Mosser, 1991). Besides that, food industry must decide not only how much to produce and also decide how much to stock. Food industry might to be reducing production costs by equalizing output overtime. The seasonal would equally result in inventory accumulation (Miron and Zeldes, 1988).
Methods to manage liquidity risk of the industry were cash flow forecasting, optimizing working capital, financing facilities and liquidity buffer. A cash flow forecast can be invaluable business tool if it was used effectively in industry (Mind Tools, 1995). It helpful to change the figures depending in activity of sales, purchases and staff costs in industry operation. Forecast will also impact legislation, interest rates and tax changes of the industry (Sahara, 2010). Cash flow forecast may consolidate problem as soon as possible and may enable to keep staff, suppliers and customers happy. For example, predicted cash levels come close to your overdraft limits, this should warning signals and trigger action to bring cash back to an acceptable level (Business gateway, 2009). Nestle (Malaysia) Berhad group monitors and maintains a level of cash and cash equivalents and bank credit lines deemed sufficient by management to finance the Group is operations and to moderate the effect of fluctuation in cash flows (Nestle, 2009). While, F & N Company adopts a prudent approach to managing liquidity risk and maintains sufficient cash (FN, 2009).
Moreover, methods to manage liquidity risk that optimizing working capital responsible for monitoring and reporting. In particular, food industry processing sector hold less inventory because food product are in general and more perishable (Schwartz and Whitcomb, 1979). That might be assuming the cost of capital to all industry from year to year as interest rates adjust. The industry may also differ to access to external finance for working capital, namely overdraft facilities and supplier credit. Cash flow was important communicate throughout the industry and a cash realization it was because promote all staff who spend and collect cash (Klaus Kremers, n.d). A worker who responsible for managing cash need understand all industry operation and alert of seasonal influenced that may cause fluctuations in need for working capital. The industry might be used cash flow forecasting together with management financial ratios such as ratios of days debtors, days creditors and days stock wills implement of working capital. Spritzer Berhad practice prudent liquidity risk management to minimize the mismatch of financial assets and liabilities and to maintain sufficient credit facilities for contingent funding requirement of working capital (Spritzer, 2009).
In addition, methods to manage liquidity risk was financing facilities that define a type of private financing available and offers various types of treatment to industry to get loan, external funding and equity. Industry must be maintaining close relationships with bankers and keeping them both financial and operational information of the industry when supplier credit and overdraft exist (Donald H, 2009). These might be state that industry to keep saving and overdraft as reserved. For Dutch lady company, they manages liquidity risk with general banking facilities to minimize the difference of financial assets and liabilities to maintain sufficient credit facilities for contingent funding requirement of working capital (Dutch lady, 2009). While, F & N Company maintains deposits and have available finding through diverse sources of committed and uncommitted credit facilities from various banks (FN, 2009).
Likewise, methods to manage liquidity risk is using liquidity buffer. For manufacturing industry that experience regular or large cash flow fluctuations, they should consider maintaining a liquidity buffer of high quality liquid assets. For example, sell down their position in business or chase up debts with more dynamism (business times, 2010).
Basically, analyze the financial characteristics between Dutch lady milk industries Berhad, Fraser and Neave Holdings Berhad (F&N), Nestle (Malaysia) Berhad and Spritzer Berhad toward liquidity risk are using liquidity ratio. The liquidity ratio based on past performance on the company with the annual report. Theoretically, liquidity ratios indicate the ease of turning assets into cash as well it indicates how capable a business in meeting of its short-term obligations. A complete liquidity ratio analysis can help uncover weaknesses in the financial position of your business. This can be referred to as comparative analysis.
The current ratio more widely used to make the analysis for short term financial position. The current assets used to fund day-to-day operation and pay ongoing expenses include inventory, receivables and prepayments, cash and cash equivalents and amount owing by related companies. The current liabilities include payables and accruals, taxation, loans and borrowings and hire purchase payables. Current ratio for year 2009 of Dutch lady milk industries Berhad is 2:1 times and Fraser and Neave Holdings Berhad (F&N) is 1.5:1 times, Nestle (Malaysia) Berhad is 1.08:1 times, and Spritzer Berhad is 2.44:1 times. The current ratios were somewhat low at Nestle Company. It is because principle of Nestle is an investment holding company of the high bank overdraft compare than other company but bank credit lines deemed adequate (Nestle, 2009). For example, manufacturing industries may maintain a current ratio 2:1 in order to remain solvent during downturn.
Quick ratio specifies whether current assets that could be fast converted into cash are sufficient to cover current liabilities. The current assets used in the quick ratio are cash, accounts receivable, and notes receivable. It is because quick ratio assumes that all assets are of equal liquidity. Analyze between quick ratios for year 2009 of Dutch Lady Company is 1.406 times, F&N Company is 0.982 times, Nestle Company is 0.577 times, and Spritzer Berhad is 2.009 times. Spritzer Berhad higher the ratio and more liquid it is. This company will be carried out any downturn in the industry compare with other food manufacturing company.
Finally, cash ratio is a more traditional and measure of a firm’s liquidity position at all. The industry holds a meager amount of cash. The industry has reserve borrowing power in banks, yet it is cash position ratio is not satisfactory. The cash ratio is an indication of the company’s ability to pay off its current liabilities if for some reason immediate payment were demanded. Cash ratio for year 2009 of Dutch Lady Company is 0.43 times higher than 0.201 times of F&N Company, 0.037 times of Nestle Company and 0.36 times of Spritzer Berhad. The Dutch Lady Company generally means have better financial shape. Nestle Company ability might be hard a bit converted into cash compare with other food industry. It is because Nestle group is exposed to foreign currency risk on sales, purchases and borrowings that are denominated in a currency other than the functional currency of the group (Nestle, 2009).
5.0 Methodology:
Cash flow forecasting
Financial analysis ratio
Methods to manage liquidity risk
Assessment of funding facilities
