Introduction
Liquidity is a critical consideration for any business. Having enough financial resources available to meet the company’s commitments is essential to the health of the organization – so it’s important to manage liquidity effectively and ensure that cash is in the right place at the right time. Corporate treasury and finance teams that prioritize liquidity planning and controls have an advantage over those that do not. And in order to make better decisions about firm liquidity, first require visibility of the company’s cash position, both now and in the future.
So what is liquidity management? And what steps should companies take to manage their liquidity as efficiently and effectively as possible?
Liquidity management definition
Liquidity is the term used to describe the liquid assets/cash a company can use to meet its current and future debts and other obligations, such as payments for goods and services. Some assets are liquid, meaning that cash can be readily accessed whenever it is needed. But other types of assets, such as longer-term investments, may take longer to convert into cash – and if such an asset has to be sold very quickly due to an unexpected shortfall, the company may end up losing some of that asset’s value.
The goal of liquidity management is to ensure the business has cash available when needed. This is achieved by managing the company’s liquidity as effectively and efficiently as possible. For companies that operate in multiple countries and currencies, and hold accounts with many different financial institutions, managing liquidity can be particularly complex. Effective bank liquidity management means using a centralized process to obtain full visibility over the company’s liquidity. Efficiency, meanwhile, can be achieved by using new methods to improve connectivity with sources of information about the company’s cash.
An important part of liquidity management is the use of techniques such as cash flow modeling. This can be used to provide the CFO, corporate treasury team and finance team with full visibility over the company’s liquidity. It is also important to have full visibility over the lines of credit available for short-term borrowing, including balances and limits – otherwise companies won’t know how much can be drawn from a particular line of credit. Liquidity management also involves managing the risk that the company will not have enough liquidity available to meet its upcoming obligations on time. This is a very real risk: even a profitable company can fail if it lacks the cash it needs to meet its commitments.
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Tracking liquidity
Maintaining proper levels of business liquidity is dependent on having a clear view over upcoming obligations, and also understanding how quickly assets can be converted into cash in order to pay for the company’s short-term, medium-term and long-term obligations. This is both an art and a science.
Where short-term liquidity is concerned, the focus is on understanding how fast the company’s short-term assets can be converted into cash. For medium and long-term assets, meanwhile, the goal is to match the maturity of the company’s investments as closely as possible with the timings of upcoming obligations so that cash will be available when needed.
Managing the different moving parts can be a complex exercise. As such, there are a variety of approaches of liquidity management. Corporate treasury and finance teams can use a toolkit of metrics to help them understand:
- Appropriate levels of liquidity that need to be maintained in order to meet upcoming obligations.
- Policies and guidelines that are needed to help guide the decision-making process.
- Ongoing monitoring of factors such as liquidity KPIs and market risks.
How to mitigate liquidity risk
Corporate treasuries must consider many different types of risk in conjunction with the bank liquidity management strategy. Some examples include:
- Liquidity risk. The risk that the company does not have sufficient liquidity available to cover its short-term needs. While this can be addressed by raising cash through credit lines or by selling short-term securities, there may be occasions when companies can’t access additional liquidity from external sources.
- Market risk. The risk that changes in prices or interest rates in financial markets will adversely affect the company’s ability to access liquidity. For example, certain markets can dry up during times of crisis.
- Credit risk. The risk that changes to the quality of a company’s credit can affect the value of its portfolio or investments.
- Operational risk. Operational risks such as the risk of fraud or human error can also result in financial loss.
All of these risks can affect the company’s liquidity position in different ways. Corporate treasury teams use a variety of different strategies to manage the risks faced by the organization, and protect the company’s cash from any negative or adverse changes.
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Cash flow modeling/forecasting
In order to manage the firm’s liquidity effectively, corporate treasury and finance teams need to have a clear view of the company’s cash position, as this will help them identify any liquidity gaps that need to be addressed. This means finding a solution for fast cash positioning and carrying out real-time cash modeling and forecasting.
- Real-time cash flow modeling provides corporate treasury and finance teams with instant access to information about cash inflows of all types, as well as the company’s liquidity options and how quickly these can be converted into cash. Cash flow modeling helps companies to gain a clearer understanding of their accounts receivable, which can be a valuable source of liquidity. It also gives the company an opportunity to offer support to customers and suppliers when needed using tools such as extended payment terms and early payments:
- Offering extended payment terms can give small business clients more time to pay.
- Paying suppliers early can give them extra support during times of adversity, such as the pandemic.
In addition, some corporate treasury and finance teams that fared better during the pandemic decided to use their excess funds to pay down debt. This wasn’t restricted to typical debt: some companies opted to pre-fund their retirement and medical obligations in order to put themselves on a better financial footing in the future.
- Cash flow forecasting is likewise an essential component of liquidity management. In order to predict the company’s ability to meet its future obligations, treasury and finance teams need to have an accurate prediction of the company’s cash position at different points in the future. This can be achieved by building a cash flow forecast based on future inflows and outflows – a process that typically involves sourcing and collating information from different parts of the business.
Cash flow forecasting is an essential part of liquidity management because of the role it plays in treasury activities such as counterparty management and supply chain management:
- Counterparty management. It’s essential to have a clear understanding of the company’s overall debt profile in real-time and across different counterparties. This is particularly important in times of crisis: banking partners will be more willing to extend favorable liquidity options at the beginning of a crisis than they will months later if they have become overextended.
- Supply chain management. Companies need a clear view of both real-time accounts receivable and supplier payments. Without this, the company won’t have the information needed to collect receivables proactively – or, indeed, to support customers when needed by offering extended payment terms. Nor will the treasury be able to help suppliers ensure their long-term success by offering support in the form of early payments. Without this option, companies could find their ability to access critical goods and materials is constrained in the future.
A global view of the cash forecast helps companies to plan ahead and assess all options to ensure that sufficient liquidity will be available when needed. It also gives companies the information they need to minimize unnecessary costs that might otherwise arise. For example, inadequate visibility over future cash flows might result in a higher cost of funding. Or a breach in loan covenants could result in a costly penalty that could have been avoided with better planning.
However, cash flow forecasting can be a challenging exercise. For one thing, internal stakeholders are not always prompt in providing the information needed to build the forecast. In addition, companies that lack suitable tools and rely on manual processes may find it difficult to create a forecast that is sufficiently accurate and timely.
With access to centralized solutions, companies will be better placed to manage an efficient cash flow modeling process. This, in turn, will enable the company to make decisions based on up-to-date, reliable information – and ensure the company’s financial liquidity position is robust, both now and in the future.
