Cash and Liquidity Management – Importance, Types & Strategies

Introduction

“Never take your eyes off the cash flow because it’s the lifeblood of business.” Who in the finance world isn’t aware of this quote by Richard Branson (Founder, Virgin Group)? This perfectly sums up the importance of cash and liquidity management in 2024 and beyond.

Picture this: There’s an unexpected dip in sales or a random expense that has cropped up. You’ll be in great trouble if systematic cash and liquidity management isn’t in place to cover expenses like bills, payrolls, or inventory purchases. That’s where the magic of cash management kicks in!

In the ever-changing world of finance and technology, smart decision-making and ensuring your business stays strong through financial ups and downs is crucial. Striking a healthy balance between having enough cash on hand and investing surplus funds to generate returns is the need of the hour. It provides you with peace of mind and a rainy day fund to tap into whenever unexpected expenses arise. 

What is Cash and Liquidity Management?

Cash management includes strategies that businesses use to manage their cash inflows and outflows. Its goal is to ensure enough cash on hand to meet short-term obligations. Liquidity management moderates the liquidity position of assets that can be readily converted to cash without significant loss.

Importance of Cash and Liquidity Management

Cash management primarily focuses on securing the now by targeting operational aspects of cash flows. It involves activities such as monitoring cash balances, processing payments and collections, and optimizing cash flows to ensure smooth daily operations. Maintaining an adequate cash position is important to cover immediate expenses, such as payroll, supplier payments, and operating costs.

On the other hand, liquidity management focuses on securing the future and involves assessing the organization’s overall liquidity needs and planning for both short-term and long-term financial obligations by considering cash and cash equivalents (such as marketable securities or lines of credit). The importance of liquidity management lies in ensuring that the organization has enough liquid resources to meet its financial commitments, tackle unforeseen expenses, and boost profitability.

Let’s now delve into the different liquidity management techniques companies employ.

Types of Liquidity Management

Liquidity management strategy

Liquidity management involves various strategies and techniques to ensure that a business maintains sufficient liquidity to meet its short-term financial obligations while optimizing its liquid assets’ use to generate returns. Read more about the two most common types of liquidity management techniques that companies typically use:

1. Cash flow monitoring

Cash flow monitoring tracks current and historical cash flows to analyze the company’s cash position.

Cash flow monitoring process involves: 

1. Automatically gather bank data from various sources such as ERPs, bank portals, spreadsheets, FP&A, and HR systems through API/ Secure File Transfer Protocol/ manual uploads.
2. Automatically reconciliation of current or prior day bank statements with cash transaction entries and identify and resolve exceptions.
3. Conduct regular assessments of daily cash positions to gain a clear understanding of available funds. 
4. Utilize visual representations like dashboards to analyze cash balances and gain quick insights into surplus or deficit situations.
5. Centralize all the cash flow data in a single repository for continuous and real-time cash flow visibility.
6. Prepare daily cash reports to present them to internal and external stakeholders.

Example of cash flow monitoring: 

Importance of cash flow monitoring:

1. Accurately generate reports: Treasury analysts can thoroughly gain an understanding of cash flows to build credible, error-free reports for leadership.
2. Identifying improvement areas: Treasury managers can pinpoint efficiency and productivity gaps to focus on areas to achieve their goals.
3. Improving decisions: CFOs can make informed choices regarding cash allocation, determining when to expand or cut down costs based on cash flow trends and patterns identified.

2. Cash flow planning

Cash flow planning involves reviewing past budgets to make adjustments for current budgeting, forecasting cash flow for a given time, and assigning amounts to spend on a company’s various costs.

Cash flow planning process involves:

1. Prepare a cash forecast by gathering your latest actuals from banks, ERPs, and other financial systems.
2. Select a cash flow model to use for forecasting different categories (such as the AI model for receivables and payables and the heuristic model for payroll and taxes) and determine the time period for your forecast.
3. Incorporate trends, seasonality, and scenarios into your forecasts based on historical and actual data.
4. Generate forecasting reports and, if needed, compare them with actuals to make adjustments.
5. Add inputs from forecasts for budgeting like planned revenue, fixed costs (salaries, rent, utilities, etc.), and variable costs (supplies, travel expenses, maintenance, etc.)
6. Analyze past budgets to determine expense and revenue expectations, prepare financial statements, and review the final budget for growth opportunities.

Example of cash flow planning:

Importance of cash flow planning:

1. Improving credit rating: Treasury managers and CFOs can build a sound cash flow plan and analyze available credit, increasing the likelihood of securing financing from investors or lenders.
2. Managing liquidity risks: CFOs can gain early warnings of potential risks and take corrective actions with a deep understanding of unexpected challenges.
3. Increasing profitability: Executives can gain a competitive edge in the marketplace by being able to spot idle cash and use it for investing in capital, mergers and acquisitions, stocks, etc.

Both cash flow monitoring and cash flow planning hold equal significance for companies of all sizes as they complement each other. Cash flow monitoring provides the necessary information for developing an effective cash flow plan, while cash flow planning helps uncover potential issues identified through cash flow monitoring.

Furthermore, both techniques can be executed by the five pillars of cash and liquidity management outlined below.

What are the Effective Strategies for Cash and Liquidity Management?

Effective cash flow management involves careful planning, proactive decision-making, and a strong understanding of your company’s financial dynamics. This includes forecasting future cash needs, accelerating receivables, and delaying payables.

Businesses, small and large, need effective strategies for cash and liquidity management to weather financial storms. The mere difference between thriving and striving is the ability to manage cash flow and liquidity positions effectively.

There are five main strategies that provide a robust framework for effective cash flow and liquidity management.

5 cash and liquidity management strategies

1. Cash flow monitoring and analysis: 

The first pillar in adequate cash and liquidity management is to monitor and analyze the organization’s cash flows. 

Cash flow monitoring and analysis process: 

• Collect and organize financial information, including income statements, balance sheets, and cash flow statements.
• Reconcile cash transactions against statements to ensure the accuracy and completeness of the data. 
• Identify cash flow trends and patterns (such as negative cash flow trends, excessive reliance on debt, or poor liquidity) through dashboards and assess the cash position of your company.
• Track your debt and equity financial instruments to improve borrowing and investing decisions.

Key cash flow KPIs: 

• Cash flow from operations (CF0): Net income + Non-cash expenses – Change in working capital
• Cash conversion cycle (CCC): Days inventory outstanding + Days sales outstanding – Days payable outstanding
• Operating cash flow ratio: Cash flow from operations / Net sales
• Free cash flow (FCF): Cash flow from operations – Capital expenditure
• Cash flow to debt ratio: Cash flow from operations / Total debt

Benefits of cash flow monitoring and analysis

Cash flow monitoring and analysis give valuable insights into a company’s cash position, helping determine its ability to meet its short-term financial obligations. 

2. Cash forecasting and planning: 

Once cash flows are monitored and analyzed, the next step is to develop cash forecasts and budgets. 

Cash forecasting and planning process: 

• Gather data from banks, ERPs, spreadsheets, FP&A, and other systems for the desired period (monthly, quarterly, or annually) and store them in a single repository.
• Perform AI modeling on complex cash flow categories such as A/R and A/P, heuristic modeling on cash flows such as payroll and taxes, and conduct time series modeling for capturing seasonality, trends, and patterns.
• Consider internal and external scenarios that may influence future cash flows, such as changes in sales, expenses, industry trends, customer behavior, and regulatory and market conditions.
• Use this information to create forecasts of expected cash flows (preferably through a cash forecasting system for speed and accuracy) and make adjustments based on your analysis.
• Review and validate the forecasted cash flows by comparing them with actuals to determine forecast accuracy. 

Key cash forecasting KPIs: 

• Forecast accuracy: (Actual cash flow – Forecasted cash flow) / Actual cash flow
• Cash flow forecast variance: Actual cash flow – Forecasted cash flow
• Cash flow coverage ratio: Cash flow from operations / Total cash outflows
• Liquidity ratio: Cash and cash equivalents / Current liabilities

Benefits of cash flow forecasting and planning

Cash flow forecasting helps in budget allocation and estimating the cash requirements for daily operations, planned investments, debt repayments, and other long-term financial commitments. 

3. Working capital management:

Cash flow forecasting provides businesses with a forward-looking perspective, providing a foundation for working capital management. 

Working capital management process:

• Get information from cash flow statements and forecasts to determine the optimal level of working capital required to support a company’s daily operations.
• Develop and implement strategies to optimize working capital management by improving inventory, receivable, and payables management.
• Continuously monitor working capital management KPIs against industry standards and targets.
• Adjust working capital management strategies as necessary based on analysis and feedback received.
• Communicate with finance, procurement, and sales teams to ensure proper execution of working capital management initiatives.

Key working capital management KPIs:

• Working capital ratio: Current assets / Current liabilities
• Days sales outstanding (DSO): (Accounts receivable / Total credit sales) * No. of days
• Inventory turnover ratio: Cost of goods sold / Average inventory
• Cash conversion cycle (CCC): Days inventory outstanding + Days sales outstanding – Days payable outstanding
• Working capital turnover ratio: Net sales / Average working capital

Benefits of working capital management

Working capital management focuses on optimizing an organization’s current assets and liabilities to ensure sufficient liquidity for daily operations. Efficient working capital management helps reduce the cash conversion cycle, minimizing the need for external financing and improving overall liquidity.

4. Liquidity risk management:

Liquidity risk management is the fourth pillar that involves evaluating and mitigating risks that impact a company’s liquidity.

Liquidity risk management process:

1. Identify and classify treasury risk exposures and their sources. Organizations should also capture emerging risks which are potential risks that they might face in the future.
2. Assess the likelihood of risk occurrence and its potential impact on the organization. 
3. Evaluate your organization’s risk appetite and compare it with the current and potential risk exposure. 
4. Proactively report risks to the stakeholders and take immediate action.
5. Manage risks by considering the following options: 

• Avoiding risks by adjusting business strategy
• Transferring risks through insurance
• Reducing the risk by introducing controls or other mitigation

Key liquidity risk management KPIs:

• Quick ratio: (Current assets – Inventory) / Current liabilities
• Cash ratio: Cash and cash equivalents / Current liabilities
• Net stable funding ratio (NFSR): Available stable funding / Required stable funding
• Liquidity coverage ratio (LCR): High-quality liquid assets / Net cash outflows over 30 days

Benefits of liquidity risk management

Through proactive risk management, businesses can devise strategies to plan for contingencies, establish credit lines or alternative funding sources, and maintain cash reserves.

5. Cash preservation and optimization

Once risks are handled effectively, companies need to optimize their cash resource utilization while minimizing idle cash balances. 

Cash preservation and optimization process:

Extract liquidity from the operating cycle and reduce cash conversion cycle by:

•  Analyze inventory turnover rates, identifying slow-moving or obsolete items, and implementing inventory control measures
• Establish credit policies, monitor and collect outstanding receivables promptly, and consider offering incentives for early payments.
• Negotiate favorable payment terms with suppliers, taking advantage of discounts for early payments, and optimizing payment schedules.
• Assess the suitable cash pooling structure based on your company’s needs and identify the central cash pool account and subsidiary accounts. 
• . Establish pooling agreements that define the terms and conditions of the pooling arrangement, including allocation of funds and interest calculations. 
• Enhance returns by investing in instruments such as money market funds, corporate bonds, certificates of deposit, and dividend-paying stocks. 

Key cash preservation and optimization KPIs:

• Cash-to-cash cycle time: Days sales outstanding + Days inventory outstanding – Days payable outstanding
• Cash burn rate: (Beginning cash balance – Ending cash balance) / Time period
• Return on cash invested: (Net income + Non-cash expenses) / Average cash and cash equivalents
• Cash flow return on investment (CFROI): (Net cash flow from operations – Capital expenditures) / Total cash investment

Benefits of cash preservation and optimization

Cash preservation and optimization enables companies to leverage their consolidated cash position to negotiate more favorable terms with financial institutions, potentially gaining access to higher interest rates on investments and/or lower interest rates on borrowings. This helps to increase profitability and improve financial performance.

While these pillars are the core steps of cash flow and liquidity management, advanced tools help you unlock the full potential of liquidity management. Below are the key features of HighRadius’ Cash Management Software that can deliver tangible advantages.

How HighRadius’ Cash Management Solution Can Help your Business

Today’s treasurers are looking for solutions that are both comprehensive and flexible. A good cash management solution, allows a company to centralize, automate, and streamline payments and cash management inside business units or throughout the entire company. HighRadius cloud-based Cash Management Solution is designed to streamline and optimize cash flow management processes for businesses that help them make better financial decisions with features like cash positioning, reconciliation, liquidity management, debt and investment management, and treasury analytics. It offers the following benefits to enable you to execute industry best practices for cash and liquidity management:

FAQs

1. What is an example of liquidity management?

A company with a monthly revenue of $100,000 collects 70% within 30 days and the remaining 30% within 60 days. To manage cash disbursements, it incurs monthly expenses of $60,000 for raw materials, salaries, and other OPEX and negotiates supplier payment terms to settle invoices within 45 days. 

2. What is the difference between liquidity management and cash management?

Liquidity management focuses on managing cash and cash equivalents to meet short-term and long-term obligations. On the contrary, cash management focuses on daily cash handling, including activities like cash collection, disbursements, pooling, and positioning.

3. What are the 4 ratios commonly used to assess a company’s liquidity?

The four commonly used ratios to assess the liquidity of a company are: 

1. Current ratio: Current Assets / Current Liabilities
2. Quick ratio: (Current Assets – Inventory) / Current Liabilities
3. Cash ratio: Cash and Cash Equivalents / Current Liabilities
4. Operating cash flow ratio: Operating Cash Flow / Current Liabilities

4. How to manage excess cash and liquidity?

To manage excess cash and liquidity, consider short-term investments like money market funds, diversifying across asset classes, and reinvesting in the business for growth. Evaluate options such as debt repayment, dividend payments, and maintaining adequate reserves while regularly reviewing and adjusting strategies for optimal results.

5. What are cash management services?

Cash management services encompass a range of financial solutions offered by banks or financial institutions to help businesses optimize their cash flow, liquidity, and financial operations. These services may include cash pooling, account reconciliation, payment processing, and liquidity forecasting to enhance efficiency and maximize returns.