Underlying Liquidity: Becoming a Cash Flow Detective

The Cash Flow Detective

Traditional financial analysis often presents a static, backward-looking snapshot of a business's health. While a company may appear solvent on its balance sheet—with assets outweighing liabilities—its real-time operational viability can be masked by underlying cash flow issues. The goal of this whitepaper is to move beyond conventional data and equip lenders with the tools to become "cash flow detectives," uncovering the hidden signs of financial stress before they escalate into a crisis. By understanding the granular details of a company's cash movements, we can shift from a reactive to a proactive risk management posture.

How often should I review my client?

The frequency of review should be determined by a risk-based approach, not a fixed schedule. Highly leveraged clients, or those with known operational challenges, may require monthly or even weekly monitoring of their cash flow by lending teams. For more stable clients with a strong track record, a quarterly or semi-annual review may suffice. The key is to establish a dynamic review process where the frequency is directly proportional to the perceived risk level. An early warning system based on real-time data allows for immediate action if key liquidity metrics begin to trend negatively, regardless of the planned review cycle.

What data is available to review my client?

A modern approach to client review requires leveraging a mix of data sources. Each source offers a different perspective on a company's health, with varying degrees of availability, cost, and convenience - something we will call (for our colleagues in commercial), “political cost”.

Traditional Data

Why are financial statements insufficient for understanding underlying liquidity issues?

Accrual accounting, window dressing, and a general lack of granularity in both depth of data and behaviour-over-time, may hide underlying liquidity issues. They are also historical documents, making them an unreliable indicator of a company's current, day-to-day liquidity.

Why are credit bureaus insufficient for understanding underlying liquidity issues?

Credit bureaus are valuable for gauging a company's historical payment performance and overall creditworthiness. However, they are fundamentally backward-looking. A credit score reflects past behavior and may not capture a sudden deterioration in a company's cash position. A client could be paying all its bills on time, but be doing so with non-operating cash or by delaying payments to non-reporting suppliers—red flags that a credit bureau report may not reveal until a default has occurred.

How do I use bank statements to identify underlying liquidity issues?

Bank statements provide a direct, unvarnished view of a company's cash flow, revealing the intricate patterns of its financial life. By analyzing them, you can move beyond static numbers to identify the core drivers of a company's liquidity.

Cash Flow Conversion Cycle (CFCC) investigation and proportional changes

The CFCC is the time it takes for a company to convert its financing and investing cashflows into commercial activity, and ultimately into cash. Bank statements allow you to observe shifts in this cycle, which serve as a critical early warning system.

Lengthening of CFCC for suppliers: Look for a pattern of later payments to suppliers. This indicates the business is using its suppliers as a source of short-term financing, a major red flag for cash flow stress. Who are these suppliers - is their own solvency at risk from the relationship? While bank statements are not usually available for the suppliers, they are an essential tool in identifying these counterparties for further concentration risk-review.

Shortening of CFCC for customers: A company may be offering steep discounts to get customers to pay faster. While this generates quick cash, it suggests an urgent need for liquidity and negatively impacts profitability. In a worst case, the company could be sacrificing its reputational risk by insisting on shorter payment terms without concessions.

Decreasing or delaying overhead expenses: Watch for a pattern of reduced spending on discretionary items, such as marketing or maintenance. This can signal that management is desperately trying to conserve cash.

Reductions in personnel, late payments in salaries, and personnel costs: Watch for changes in patterns in monthly salary overheads, irregularities or cessation in payments to specific contract employees, and inflated final paychecks with holiday pay.

Non-operating cash inflow as coverage for operating and financing cash outflows: A healthy business should fund its existing operations from its existing core business activities. If you see non-operating cash inflows (e.g., asset sales, new loans, or owner injections) being used to cover recurring operating or financing expenses, it could be a sign of a underlying liquidity issues. While a bank statement cannot tell you if a business intends to scale or diversify operations, changes in behaviour can prompt the right questions - questions that need to be asked to understand a lenders true exposure.

Challenges of using bank statements for understanding underlying liquidity issues

While powerful, bank statement analysis is not without its challenges. The most significant hurdles are data access and data hygiene. Gaining a client's consent to access their bank account data can be a sensitive process. Once granted, the data itself is often messy, with transaction descriptions that are inconsistent and difficult to categorize. This requires sophisticated software and algorithms to parse and interpret correctly. Without proper tools, the sheer volume of data can be overwhelming and the risk of misinterpretation is high.

Prestatech: The Cash Flow Underwriting Tool

We at Prestatech understand and thrive in solving the challenge of unlocking cash flow underwriting for our partners. As ex-lenders turned credit-as-a-service providers, we have a wealth of experience in the efficient aggregation, classification, and analysis of cash flow data for use in both IRB rating models and manual underwriting workflows, as well as monitoring and portfolio analysis. Prestatech provides a scalable, auditable and configurable workflow in use by Banks and Lending institutions across Europe, the UK, and the US. Get in touch for a demo.