Introduction to liquidity management: objectives, risk & strategies

For almost every company, it is important to remain financially agile. It enhances preparedness for potential business risks and enables quick decision-making. Without good visibility into the liquidity, sudden business risks can easily disrupt your company, and in the worst-case cause insolvency. It can also prevent companies from capitalizing on business opportunities, which is when they start losing their competitive edge.

Accurate liquidity management can make a big difference in the success of your business. When done right, it provides insights into your cash position in the past, present, and future, and how it will be affected by cash outflows or short-term liabilities, thus giving you a good outlook on the financial health of a business.

Yet, the challenge for medium or larger-sized companies is that it is difficult to get real-time and accurate financial information on where they stand at any point in time. In turn, this often slows down the whole company in the long term due to longer strategic decision-making processes. Therefore, it is extremely important for companies to have a proper liquidity management strategy in place to mitigate any liquidity risks and to make the company financially agile.

What is liquidity management?

Liquidity management should be a priority for all companies. It gives a clear indication of financial health, and it provides visibility into how well a company can afford its current and future debts, short-term investments, obligations, and spend with its liquid cash and assets at hand. Optimal liquidity management enables complete visibility into financial resources, spend, cash, and liabilities at any point in time. So, you can make informed strategic decisions faster.

Several stakeholders such as managers, lenders, and investors are interested in the liquidity of companies and measure it with different ratios to analyze financial performance and risks. When doing so, liquid assets are typically compared with short-term liabilities to see whether companies can meet their debt obligations, pay out bonuses, or make any excess investments. Ideally, companies have the ability to meet debt obligations with their cash and assets in a timely and sustainable manner.

The objectives of liquidity management

Each company has its own objectives for liquidity management, but there are a few common ones that generally apply and should be considered by finance and treasury teams.

Minimize liquidity risk

One of the main objectives of liquidity management for every company should be to minimize the risk of having a shortage of liquid assets to pay creditors. In other words, maintaining cash positions that allow you to meet your daily obligations. Minimizing liquidity risk helps you to avoid any insolvency issues.

Capture the financial health of the company

Even though there are a variety of metrics to capture the financial health of a company, liquidity measurements should remain the primary indicators. Liquidity analyses provide good insight into how well a company is able to pay its creditors in a timely and orderly fashion.

Predict future cash positions

Accurate liquidity management should aim to provide insights into the past, current, and future financial conditions and cash positions. When it becomes clear how much cash you have at hand now and in the future, it helps your team make informed and quick strategic decisions.

Increase business agility

When you know that your company is financially healthy when it becomes easier to speed up bigger strategic decisions because you know where your business is standing and what is financially feasible. This way, you can capitalize on market trends faster or take other strategic decisions promptly to grow your business further.

Attract additional financing

By lowering your liquidity risk, it becomes easier to attract additional financing with good terms and conditions as your bargaining power will become stronger. It is always a best practice to be on top of your liquidity management, especially so when you are seeking a party for external capital because they will scrutinize the financial risks before lending you the funds for your investments.

Liquidity management risk

Liquidity risks are vulnerable financial areas that finance teams should always look out for. When liquidity management is not done well, the consequences of it can be as catastrophic as having to shut your business down. There are several common liquidity risks that businesses can face:

Inability to pay debt, suppliers, creditors, or other obligations (insolvency risk)

If cash inflows are lower than forecasted, it can mean that you won’t be able to pay your suppliers, lenders, or other obligatory payments. Credit risk can result in the need to sell illiquid assets at a lower price than their fair value. A continuous inability to pay debt and suppliers over a longer period can even cause insolvency.

Inability to attract additional financing

Having an overleveraged business does not look attractive when you are looking to secure financing. Other parties are less likely to invest in your business or lend you capital when your company holds a bad reputation in respecting loan and debt agreements. Even if you manage to sign a new agreement, the rates, terms, and conditions are likely to be suboptimal. This can seriously limit the growth of your company.

Poor visibility

Poor visibility into your liquidity position can cause unexpected surprises like sudden expenditures or disruptions in cash inflows. Depending on the financial strength of your company, this can cause issues when needing to pay your creditors. Poor visibility is common when companies are becoming more complex with an increasing number of banks, accounts, suppliers, customers, ERP systems, etc., in multiple countries as data is often scattered.

Lack of centralization

Centralization of data is a common issue whether your company is growing, or it is already larger. Besides decentralized systems being highly inefficient, it can increase the liquidity risk because you may miss important data while gathering it all from multiple sources. Again, this possibly leads to unwanted financial surprises.

Operational risks

There is always the risk that something operational goes wrong such as human errors and fraud occurrence. As a result, you can face discrepancies between cash inflows and outflows that can harm your liquidity position.

Strategies to manage liquidity risk

Managing liquidity risk as well as you can is important to mitigate any of the harmful financial consequences we mentioned before. Companies at different financial maturities strategize for liquidity risk in various ways, here is an overview of the most common ways to manage liquidity risk:

1. Develop accurate cash flow forecasts

Accurate cash forecasting is at the core of excellent liquidity management. By developing accurate cash forecasts, you can easily measure your cash positions at different points in time and see how well they perform against short-term liabilities that must be paid. This enables businesses to allocate cash to other purposes besides paying creditors without hesitation and long decision-making processes.

2. Examine counterparty insolvency risk

Before entering business with counterparties, make sure to examine their liquidity risk. You do not want to miss out on a critical amount of money due to the insolvency of a counterparty.

3. Have policies and guidelines in place for decision-making

By making sure you have guidelines and policies in place regarding the allocation of cash you can avoid investments that could harm the financial strength of your company. This way, your liquidity position will remain at good levels.

4. Analyze external risks

External trends like market risk can have a major impact on your company’s liquidity. Increased interest rates and higher prices can heavily affect your company’s capability to access liquidity. Financial crises as well as the recent COVID-19 circumstances are good examples of external trends that have disrupted liquidity. Hence, it is important to consider similar potential external risks.

5. Prevent operational risks

Operational risks like human errors as well as fraud can be detected and prevented by having the right systems, processes, and controls in place. Once operational risks are tackled properly, liquidity risk decreases significantly.

6. Effective receivables management

Make sure that parties that are supposed to pay you do so in a timely and orderly fashion. This is crucial for your own business to have the amount of cash available to pay debtors and suppliers.

7. Frequent analyses

Remember to analyze your liquidity and cash in and out-flows periodically to stay on top of your company’s financial health. Only this way you can mitigate any risks that threaten your business.

8. Centralize all financial data

With an increasing number of banks, accounts, suppliers, customers, ERP systems, subsidiaries, employees, processes, and excels, it becomes challenging to manage liquidity. It means that you need to trust everyone to contribute with their timely and error-free data input to be able to analyze liquidity accurately. Finance and treasury teams can save time and resources, and prevent errors, by centralizing all data into a centralized liquidity management system.

9. Automated reporting

Automated reporting for liquidity management decreases the risk of human-made errors and it frees up a significant amount of time compared to manually reporting on liquidity on a regular basis. Especially when you need to pull your data from multiple source systems.

10. Consider seasonal adjustments

If your business is highly sensitive to seasonality, you may want to consider seasonal adjustments in your liquidity analyses. It can mean that your cash inflows and outflows vary depending on each season, which must be accounted for to make sure you can continue paying your creditors.

11. Use predictive analytics

Predictive analytics especially powered by machine learning (ML) or artificial intelligence (AI) can help you to simulate forecasts as detailed as possible by anticipating external events, seasonality, and even industry-specific indicators. On top of that, algorithms can be used for customized input of cash flow irregularities. This allows your business to hedge against liquidity risk as well as possible.

How liquidity management solutions can help

No matter what the size of your company is, but especially with medium to larger sized ones, it can be helpful to use a solution for managing liquidity. Liquidity management systems can benefit companies with complex technical ecosystems by centralizing all the required data for accurate liquidity analyses and reporting.

Most solutions can also help you collect cash flow forecasts and actuals, across a range of systems to improve your cash visibility. And with the help of automated and flexible reports, you can easily gain real-time insights into your company’s liquidity. As a result, you can make more informed decisions at a higher speed without worrying too much about liquidity risks, whether it is for business continuation, growth, or additional financing.