Liquidity, in business, means the ability to pay when due. Liquidity and bankruptcy are on the same number line but on two opposite ends. Therefore, it is in the business’s best interest to keep the Liquidity-Bankruptcy indicator on the side of liquidity. We should strike a balance because low liquidity poses the risk of bankruptcy, and on the other hand, too high liquidity indicates inefficient cash management. Therefore, in this article, we will be reading about various methods of effective cash management.
The best tool to measure liquidity is liquidity ratios such as the current ratio, acid-test ratio, or quick ratio. Keeping these ratios optimized will automatically improve the company’s liquidity position. An appropriate liquidity ratio is one of the eligibility requirements for short-term loans.
- How to Improve Liquidity by Effective Cash Management?
- Common Ways of Improving Liquidity
- Improve Sales of High Margin Products / Reduce or Eliminate Loss-Making Products
- Invoicing Discipline
- Crystal Clear Terms of Credit
- Cash Flow Forecasting
- Minimize Cash Flow Risk by Availing Insurance
- Current Assets Financed through Long Term Sources
- External Services for Improving Liquidity
How to Improve Liquidity by Effective Cash Management?
There are various ways and means of improving liquidity. Some common ways and other innovative ways are as follows. All Finance Professional or Entrepreneur knows the common ways, but some creative ways may skip from their mind.
Common Ways of Improving Liquidity
Common ways of improving liquidity are as follows:
- Speed Up the conversion cycle of Debtors or Account Receivables.
- Delay in Purchases.
- Sell off unproductive assets.
- Cash sweep.
- Managing collection floats.
Improve Sales of High Margin Products / Reduce or Eliminate Loss-Making Products
To implement this measure, one must analyze each of their products in terms of their margins and volumes. The loss-making or very low-margin products, we may either eliminate completely or hike their prices if the market permits. An appropriate and efficient product sales mix can generate higher margins and, therefore, a higher amount of cash is available for disposal.
Everybody knows that the sooner you raise the invoice, the sooner will be the realization. But still, most businesses are not disciplined in this respect. It is very important to raise invoices on time and with 100% accuracy to save the time and energy wasted in creating credit notes, resolving billing issues, etc.
Crystal Clear Terms of Credit
The credit terms should be crystal clear and should be documented, agreed and duly signed by the parties. It applies to both creditors (liquidity providers) and debtors (liquidity users) simply because both are relevant for liquidity considerations. This avoids a lot of nuisance related to legal suits, post-supply negotiations, rebates, discounts, time of payment, collecting interest on delayed payments, etc.
Cash Flow Forecasting
Detailed cash inflow and outflow forecasting can work as a management information report. It can give appropriate time for managing the cash in the coming future and help decide levels of cash. This is an effective cash flow management tool and is practiced at big corporate houses.
Things that may be missed and require special attention are sensitivity analysis of debtors’ obligations, consideration of rebates, discounts, etc. Keeping a regular check on the availability of funds from external sources is necessary because such funds available today may not be available in the future. Bad debts are normally provisioned at the end of the year, but forecasting is done weekly, fortnightly, or monthly. This should also be a point of consideration at the time of forecasting.
Minimize Cash Flow Risk by Availing Insurance
Payment obligations towards creditors are met out of the obligation of accounts receivable. In case a big customer becomes insolvent. Consequently, we come in a position to dishonor our payment obligations. This is a credit risk, and we should take insurance for Credit Insurance / Debt Protection. Since it also involves premium cost. The finance controller needs to analyze the debtors and may only avail such insurance for the high-risk debtors. This technique does not generate cash but puts more assurance on future cash inflows. It helps in making cash flow forecasting more reliable.
Current Assets Financed through Long Term Sources
At the time of financing the current assets by long-term sources of financing, the cost of financing is low, thereby saving the business’s interest costs. This reduces the requirement of cash to pay the interest on short-term borrowing, improving the short-term availability of cash for the business.
External Services for Improving Liquidity
The management can internally exercise all the points discussed above, whereas some good external services also help in improving the liquidity and its management. Factoring is one such service whereby the debt of a business is collected by a bank or any other financial institution for a fee. Invoice Financing is a short-term loan available for urgent cash requirements.
The above-mentioned are some of the commonly used methods of effective cash management. Not only this, but these techniques also help in arriving at the optimal level of working capital. Better management of cash will eventually lead to a smooth working capital cycle.