Liquidity Management Vs Capital Management

Newton’s Law in Aged Care?

For every action, there is an equal and opposite reaction – who would have thought Newton's Third Law would apply to aged care!

The release of the final draft of the Financial and Prudential Standards requires providers to focus on their Liquidity Management Strategy. So where does Newton fit into this? There has been much talk about the investability of residential aged care. Commercially, investability boils down to Return on Equity (ROE). Investors will invest wherever they can earn an appropriate risk-adjusted ROE. You change ROE by increasing profitability or reducing the equity you commit to an investment.

Clause 12 of the Standard requires the Registered Provider (RP) to “maintain the provider’s default minimum liquidity for the quarter at all times during the period”.  This means the RP cannot use the default Minimum Liquidity Amount (DMLA), so any excess liquidity has to be matched by an increase in equity. 

So, there you have it – Newton's Law as it applies to aged care: The greater the Minimum Liquidity Amount, the more equity is required – increasing pressure on ROE and reducing residential aged care investability.

The Capital Cost of Excess Liquidity

At its core, liquidity management is about ensuring an entity has sufficient reserves to manage the risks and uncertainties of its activities. The Australian Prudential Regulatory Authority (APRA), which regulates banks and insurance companies, has determined that this is best achieved through regulating capital (the amount of shareholders' money locked into the company). Aged care has not adopted this approach and instead relies on prescribed liquidity levels via the DMLA.

Because the DMLA is a one-size-fits-all solution and it requires funds to be held aside continuously, this removes them from operational use. The Standard requires the DMLA to be in cash or readily convertible to cash, which almost guarantees that the yield on these funds will be much lower than the MPIR. So the net effect of mandating liquidity is to negatively impact profit and negatively impact capital.

Why Providers Really Fail

We’ve previously analysed the cost to government of provider failure under the Aged Care (Bond Security) Act and concluded that it is trivial in the context of the sector's total bond liability. 

Providers do not fail because of illiquidity in relation to RAD liabilities. Providers fail because their businesses are generating losses and they don’t have the capital to cover these losses. While mandating liquidity may indirectly cause a provider to use more capital, it is an inexact mechanism to ensure financial sustainability.

A Smarter Liquidity Framework

Under the Evaluated Minimum Liquidity Amount (EMLA), a provider is required to: 

“have arrangements in place that ensure the provider can meet the provider’s financial obligations as they fall due; and refund, deposited amount balances in accordance with the Act and withstand a sudden or unexpected financial shock and the arrangements must not pose a greater risk than if the provider were to maintain the default minimum liquidity amount.”

The key difference between the DMLA and the EMLA is that you can use the funds that have been set aside as part of the arrangement - Capital Efficiency 101. More importantly, because you can use the arrangements, it is unlikely that you will ever be in default of the EMLA. In contrast, if you use the DMLA, you are automatically in default the moment those funds are accessed.

The long-term risk to repayment of RAD is unrelated to the RAD liquidity. The risks are: 

• The provider has misused RAD, which can occur in respect of 90% of RAD that is not subject to the DMLA.
• The value of the facility is less than the RAD invested in it - this is the intended use of RAD. This relates to capital allocation governance principles.
• The provider is financially unsustainable and ultimately goes into liquidation - a function of governance, management capability and government funding of care and accommodation for supported residents.

If you agree with the above, then the only argument for a RP adopting the DMLA is that it is less than the EMLA. Interestingly, if this is the case, then the DMLA provides less buffer against failure than the EMLA. 

APRA is a highly regarded regulator, so we looked at the EMLA from a risk perspective. We were surprised by how little liquidity is required when you take this approach. While every case is different, it's not unusual to see that: 

• The RAD liquidity requirement is less than 5%
• The working capital requirement is less than half of the DMLA

Relating this back to Newton’s law, adopting EMLA can significantly decrease the amount of capital tied up in prudential reserves and arrangements – meaning the provider needs less capital and more funds are available to be put to work generating returns that increase long-term sustainability and, in turn, investability of the sector. 

With the drought of new residential developments and the tsunami of demand, we think responsible RPs should opt for the EMLA and provide older Australians with the residential facilities they need and deserve.

Need Help with Your Liquidity?

We have developed a robust methodology to assist providers quantify their EMLA and the associated liquidity management policies and processes necessary to maintain compliance with the new Standards.

If you need assistance taking control of your liquidity under the new Standards, get in touch.

Contact us

Upcoming Webinar: Liquidity Management – Simple or Effective?

The new Liquidity Standards offer aged care providers a choice: Accept the Default Minimum Liquidity Amount (DMLA) – the simple option, or determine your own Evaluated Minimum Liquidity Amount (EMLA) – a more accurate and strategic option.

This webinar will explain why the EMLA is not just the more effective choice – it’s the safer one. With upcoming changes in RAD repayment timings and critical distinctions between “arrangements” and actual cash holdings, many providers risk breaching their liquidity minimums if they rely on the default approach. 

Join aged care advisors Stephen Rooke and Bruce Bailey for a practical session covering:

• The differences between the current and new liquidity rules
• How to calculate your organisation’s EMLA
• Our recommended checklist for compliance and assurance
• A walkthrough of our Liquidity Management Strategy template
• Barry Ashcroft at Apollo Care will also join as a guest speaker, sharing how we worked with Apollo Care to develop their EMLA and associated Liquidity Management policies and processes.

As part of the session, we’ll introduce a new Liquidity Management support service, developed to help providers implement the EMLA confidently. Webinar attendees who subscribe to this service will receive a rebate on the webinar registration fee.

This session is ideal for C-suite, Board, finance committees and finance managers seeking clarity and control under the new framework.
 

To learn more about the webinar and register, click here.