The Benefits of Liquidity Management

Running a business isn't easy, especially if a company operates on thin margins. This means that effective liquidity management is one of the most important parts of any company's daily operations. Creating an agile liquidity management plan allows a company to optimize its working capital and be prepared to meet its short-term financial obligations as well as its long-term financial commitments.

But understanding liquidity management isn't simple. Here are some things you should know about it.

 

What Is Liquidity Management? 

Liquidity management is a company's strategy for managing its cash flow and liquid assets in a way that ensures it can meet its financial obligations and operational needs. A critical component of a company's financial performance, liquidity management is directly related to its working capital.

By managing working capital with effective liquidity management, a company can help itself avoid financial distress, optimize its use of capital and be prepared for unexpected expenses and opportunities. It can also make informed decisions based on real-time financial data. 

 

What Are the Types of Liquidity? 

To develop an effective liquidity management strategy, it’s important to understand the different types of liquidity. That way, leaders can be sure their strategy will meet all the company’s needs. 

Market Liquidity

Liquidity in the market refers to the abundance of buyers and sellers and the stability of asset prices. It’s vital to consider market liquidity when making investment decisions, as it will affect the ease or difficulty of buying or selling an asset.

Accounting Liquidity

Accounting liquidity measures the company’s ability to meet its daily operational expenses, such as inventory and payroll costs. Because this affects a company’s solvency, it is the most important type of liquidity.

Funding Liquidity

A company’s ability to finance the purchase of assets with available credit is its funding liquidity. This includes the company’s ability to make agreed-upon payments on time.

Operational Liquidity

Operational liquidity refers to the availability of funds for a company to perform normal business operations, such as paying rent, salaries, interest expenses, and other typical expenses associated with operating the business.

 

What is the Importance of Liquidity Management?

Liquidity management allows companies to access cash when they need it. The cash, or liquid assets, helps the business meet short-term obligations, such as covering debt payments, purchasing merchandise or services, or short-term investing. By meeting short-term obligations, the company can become more financially efficient.

Finance teams can use liquidity management to strategically move funds from one area of the business to another area to meet a critical short-term need. They can also tap into hidden liquidity by adjusting their supply chains and cash requirements.

 

Best Practices & Benefits of Liquidity Management

 There are several best practices that can help lead finance teams to effective liquidity management.

They include the following:

• Maintain transparency into cash inflows and outflows, keeping track of invoicing, payment schedules, and expenses.
• Track accounts receivable (AR) and accounts payable (AP).
• Create an accurate cash flow forecast through inventory management and financial statement reviews.
• Plan for the future with accurate cash flow and financial data.
• Regularly update financial plans as expenses and plans change.
• Compare targets to performance.

Companies can use liquidity management tools to help manage these tasks. Tools like these can connect to a company’s bank accounts to automatically retrieve transactions and update cash flow planning. 

Solid liquidity management offers a number of benefits. It provides leaders with a better understanding of the company’s financial health. It can also help companies maximize liquidity, reduce expenses, increase efficiencies and make more informed decisions.

 

Risks to Consider With Liquidity Management

As with any type of financial planning, there are risks to look out for when strategizing liquidity management.

There are many factors that can affect a company’s cash flow and liquidity. Some of the most common items that affect liquidity risks include:

Inventory

When a company has too much inventory, it has working capital tied up in inventory costs that could be used more effectively in another way. However, too little inventory may lead to lost sales or delays in production.

Outstanding Payables

The money that a company owes to its suppliers can negatively affect liquidity. To manage this risk, a company can often access discounts for early payment or take advantage of extended payment terms.

Reduced Credit Limits

When companies don’t have access to credit due to economic conditions or other reasons, they may be forced to pay cash for supplies and inventory. That can create a cash flow crunch.

Seasonality

Many businesses see demand for their products and services fluctuate throughout the year. For example, lawn care services might see demand spike during the warmer months, while retail stores experience higher sales during the holiday season. These ups and downs can affect liquidity risk.

Uncollected Receivables

When customers owe a business money for goods or services that have already been provided, the business may experience a cash crunch.

An effective liquidity management strategy considers a company’s potential liquidity risks as well as cash opportunities and includes plans for maximizing cash positions and financial efficiencies.

To help your business better manage its cash and be prepared for the future, consider taking advantage of liquidity management solutions, like those available from City National Bank.