Beyond Profit: The Essential Role of Liquidity Management in Business Success

What is liquidity management?

One of the core ingredients to a successful and sustainable business is optimal liquidity management. Liquidity management involves careful planning of a company’s cash flow to ensure it has sufficient liquid assets to meet short-term obligations. This process includes forecasting cash flow, managing working capital, and strategically planning for both expected and unexpected financial needs.

Who needs to manage their liquidity?

It is a common misconception that targeted liquidity management is only needed for larger corporations, while small and medium-sized enterprises (SMEs) and sole proprietorships can get away with rudimentary or informal liquidity management processes. This is simply untrue, as every business, from startups to multinational corporations, needs to manage liquidity properly. In fact, careful liquidity planning can be even more vital for smaller businesses and startups who often face greater liquidity challenges and constraints, while larger companies tend to have more resources and easier access to capital.

When the crisis hits: acute vs ongoing liquidity management

It’s crucial for businesses to maintain optimal liquidity management at all times, but it becomes especially critical to act fast and secure adequate liquidity when a financial crisis hits. In this respect, we can distinguish between acute and ongoing liquidity management:

Acute liquidity management

Acute liquidity management focuses on immediate cash needs during a sudden liquidity crisis. This could be brought on or exacerbated by economic downturns, market crashes, unexpected expenses, or a general failure to ensure optimal liquidity on an ongoing basis, culminating in a liquidity disaster. Strategies for acute liquidity management include:

• Securing emergency funding or extending existing credit lines,
• Suspending loan repayments or negotiating extended payment terms with suppliers,
• Liquidating non-essential assets,
• Halting all non-essential expenditures,
• Sending out requests for debtors to pay their accounts, and issuing demand letters to those whose repayments are already overdue.

Ongoing liquidity management

It’s important to understand that acute liquidity management strategies are a last resort and should only be exercised in extreme cases where there are no other viable means to acquire liquidity. This is why it’s so vital to effectively manage liquidity on an ongoing basis, as it helps prevent the crisis from occurring in the first place.

Ongoing liquidity management involves continuous monitoring and planning to maintain optimal liquidity under normal business conditions. This includes regular cash flow forecasting, managing working capital, and maintaining adequate credit lines.

We will primarily focus on sound ongoing liquidity management practices for the rest of this article.

Why is optimal liquidity management important?

Financial stability hinges on optimal liquidity management, as it ensures that a company can meet its short-term obligations, such as payroll, supplier payments, and other operational expenses. However, the reasons for liquidity management go far beyond ensuring short-term solvency alone. They also include:

• Growth and investment opportunities: Adequate liquidity allows a company to invest in growth opportunities with greater confidence, such as expanding operations, launching new products, or entering new markets.
• Risk mitigation: Proper liquidity planning allows businesses to identify potential liquidity risks early and take appropriate action. Maintaining healthy liquidity levels helps companies withstand economic downturns, market volatility, and unexpected expenses or losses without disrupting operations.
• Creditworthiness: Consistent management of liquidity helps maintain a good credit rating by ensuring timely debt repayments, which is essential for securing favorable financing terms and credit lines in the future.

Benefits of good liquidity management

In addition to the core reasons mentioned above, effective liquidity management also offers the following benefits:

• Improved cash flow: Optimizes the inflow and outflow of cash, ensuring smooth business operations.
• Enhanced decision-making: Provides better financial visibility, enabling informed strategic decisions.
• Cost savings: Reduces the need for expensive short-term borrowing and minimizes interest expenses.
• Increased investment returns: Ensures surplus cash is invested wisely to generate higher returns.
• Business resilience: Enhances the ability to navigate economic uncertainties and financial crises.

Tips for effective liquidity management

Effective liquidity management involves careful planning and consideration of various factors. Here are some practical tips to help you manage liquidity effectively and avoid potential solvency issues:

1. Always have a thorough liquidity plan

A well-structured liquidity plan is the foundation of effective liquidity management. The liquidity plan is essentially a projection of the difference between cash inflows and outflows resulting in the net cash flow of the business. The plan should outline detailed cash flow projections, anticipated expenses, and potential sources of funding. The liquidity plan should include projections for the next 12 months. This allows you to spot potential liquidity issues early and take appropriate action. Regularly update the plan to reflect changes in the business environment and actual financial performance.

We will explore the practical aspects of how to create a good liquidity plan later in the article.

2. Plan your purchasing

Strategic purchasing decisions can significantly impact liquidity, so it’s important to be proactive and disciplined about your approach to purchasing. Try to negotiate favorable terms with suppliers and take advantage of bulk discounts and other beneficial purchasing conditions when they present themselves while avoiding overstocking your inventory. Additionally, ensure you maintain clear purchasing budgets and rules about who is entitled to place orders within your company.

3. Cost control

Just as important as establishing clear purchasing guidelines is implementing effective cost control measures to save cash. Regularly review your spending to identify areas for cost reductions, such as renegotiating contracts, reducing waste and optimizing resource utilization. Effective cost control can significantly improve cash flow and increase liquidity.

4. Efficient accounts receivable and accounts payable management

Managing accounts receivable and accounts payable efficiently is crucial for sound liquidity management. The basic aim is to have your debtors repay you as soon as possible, while extending your creditor repayment timelines without incurring penalties or reputational damage. This involves implementing prompt invoicing and follow-up procedures to ensure timely collections. At the same time, negotiate extended payment terms with suppliers to delay your cash outflows, except in cases where you can take advantage of early payment discounts.

Tips for efficient accounts receivable management:

• Send invoices immediately after sales and/or provision of services,
• Record customer orders and payments accurately and systematically (avoid mistakes and omissions in invoicing),
• Enlist the services of professional debt collectors if needed.

Tips for successful accounts payable management:

• Take advantage of early payment discounts offered by suppliers when cash flow permits,
• Prioritize payments based on due dates and negotiate longer payment terms where possible,
• Maintain good relationships with suppliers to facilitate flexible payment arrangements,
• Schedule regular reviews of outstanding payables to avoid late payment penalties and manage cash flow effectively.

5. Ensure you have multiple credit lines

Having access to multiple credit lines provides financial flexibility. It’s always advised to establish relationships with various financial institutions as opposed to working with only one bank. This makes it easier to secure additional lines of credit and business loans when you need them most. Multiple credit lines ensure better liquidity during times of financial constraint or when taking advantage of growth opportunities.

6. The goldilocks zone: how much liquidity do you need?

Optimal liquidity management is not as simple as trying to maximize short-term liquidity, as every franc you keep as liquid cash on hand is one that cannot be invested in higher yielding long-term asset investments. Maintaining the right amount of liquidity is therefore essential. Too little liquidity can of course lead to financial distress, while excessive liquidity can result in missed investment opportunities, thereby reducing overall profitability.

Smart cash flow management is therefore a constant balancing act between ensuring adequate liquidity to meet short-term payment obligations and maximizing long-term profitability. This is why a comprehensive liquidity plan is essential for regularly assessing your liquidity needs based on cash flow forecasts, business cycles, and market conditions to find the optimal balance.

7. Using software

Accounting software has become increasingly advanced and user-friendly. You can use these applications to automate your cash flow forecasting, monitor expenses, and manage accounts receivable and payable. Comprehensive ERP solutions like Microsoft Dynamics 365 Business Central seamlessly connect all your financial transactions, payroll, and cash flow management needs. These solutions also provide real-time financial insights and streamline your liquidity management processes.

That said, accounting software does require a certain level of expertise to handle correctly, and you may feel more comfortable going the traditional route and using programs like Microsoft Excel to manually create and manage your liquidity plan. If your situation is not overly complex with only a few different deposits and withdrawals, Excel can be the simplest and clearest tool.

8. Get professional support

Even though technology has come a long way in enabling business owners to take control of their own cash flow management, in most cases, the expert support of a professional accountant or financial advisor is indispensable. They can provide valuable insights and strategies tailored to your business needs which go far beyond the simple automated cash flow planning you get from an accounting program. They also have the deeper skills and knowledge required to help you maximize the benefits of advanced cash flow planning tools and processes. 

How to create a good liquidity plan

We have stressed the importance of a well-structured and realistic liquidity plan for effective liquidity management. Let’s discover more about what should be included in a liquidity plan and the steps for creating one:

What should you include in your liquidity plan?

1. Cash flow projections

The bulk of your liquidity plan is made up of detailed projections of cash inflows (deposits) and outflows (payouts) for various time periods (typically the next 12 months).

Deposits include:

• Invoice payments from customers, discounted by approximately 3 – 5 percent to factor in the risk of payment default,
• Reimbursements from insurance companies, tax rebates, and other similar receipts,
• Grants and subsidies from government or other financial aid programs,
• Cash inflow from credit institutions, such as bank loans and other credit lines,
• Investment income from interest or dividends on stocks, bonds, or other financial instruments,
• Proceeds from asset sales,
• Equity deposits from founders, investors, and shareholders,
• Licensing and royalties income from intellectual property, patents, trademarks, or other licensing agreements.

Payouts include:

• Payments of supplier invoices,
• Cash outflows for overheads such as rent, electricity, internet, marketing, insurance, and other fees,
• Expenses related to the purchase, leasing, or maintenance of machinery, vehicles, and other equipment,
• Salary and wage payouts,
• Research and development (R&D) costs associated with the development of new products, services, or technologies.
• Taxes and administrative fees,
• Loan repayments including interest,
• Investments,
• Dividends and profit distributions to investors or shareholders,
• Expenses for employee training programs, professional development courses, and other skill enhancement activities.

2. Expense analysis (optional)

It is useful to include a comprehensive breakdown of your fixed and variable expenses (i.e., expense analysis), which can help identify areas for cost reduction and efficiency improvements. While not directly connected to cash flow, conducting an expense analysis can provide valuable insights into your spending patterns and pinpoint opportunities for cost-saving measures that can ultimately improve your liquidity position.

3. Funding sources

Your cash flow projections provide greater insight into your current liquidity situation as well as your liquidity needs going forward. Part of this is accessing credit and other sources of funding at the right time to ensure you always have adequate liquidity. Identify potential funding sources, such as credit lines, loans, and investments.

4. Contingency plans

In the world of business and finance, things rarely go perfectly to plan. It’s vital to always be prepared for unexpected financial disruptions and less favorable outcomes than anticipated. Planning out contingency strategies can help ensure your business is able to respond quickly and effectively to unforeseen events.

5. Performance metrics

Finally, your liquidity position should be summed up with Key Performance Indicators (KPIs), including commonly accepted liquidity ratios. These metrics provide a quantitative snapshot of your overall liquidity health and can be compared with past measures to gauge improvement, competitors, and industry benchmarks. The liquidity ratios are also one of the first things that credit institutions and other potential lenders look at when determining your creditworthiness and deciding whether to grant you additional loans.

Some of the most useful and widely acknowledged KPIs and liquidity ratios to include in your liquidity plan are:

1. Net Working Capital (NWC): Indicates the difference between a company’s current assets and current liabilities, providing a measure of short-term financial health and liquidity.

NWC = Current Assets – Current Liabilities

The NWC should be tracked to maintain a healthy balance between current assets and current liabilities. The evolution of NWC gives an indicator of how free liquidity changes over time.

2. Current Ratio: Measures a company’s ability to pay short-term obligations with its current assets.

Current Ratio = Current Assets / Current Liabilities

The current ratio should always be kept above 1 to ensure good short-term financial health.

3. Quick Ratio (Acid-Test Ratio): Provides a more stringent measure of liquidity by excluding inventory from current assets.

Quick Ratio = (Current Assets – Inventory) / Current Liabilities

Aim to also keep the acid-test ratio above 1 if you want to have greater confidence about your liquidity position without relying on inventory.

4. Days Sales Outstanding (DSO): Indicates the average number of days it takes to collect payment after a sale.

DSO = (Accounts Receivable / Total Credit Sales) * 365

Aim to reduce the average accounts receivable collection period as much as possible to improve cash flow.

5. Days Payable Outstanding (DPO): Shows the average number of days a company takes to pay its suppliers.

DPO = (Accounts Payable / Cost of Goods Sold) * 365

Generally, a longer DPO is preferable, but it should ultimately be optimized to balance timely payments with longer cash retention.

6. Cash Conversion Cycle (CCC): Measures the time it takes for a company to convert its investments in inventory and other resources into cash flows from sales.

CCC = Days Inventory Outstanding (DIO) + Days Sales Outstanding (DSO) – Days Payable Outstanding (DPO)

Aim to keep the CCC as low as possible. The CCC should be continuously monitored to ensure efficient cash flow management.