Imagine yourself as the captain of a ship, embarking on a daring expedition to explore uncharted territories in search of hidden treasures. As the captain, you understand the paramount importance of having ample supplies to sustain your crew throughout this long and uncertain voyage. In the realm of finance, liquidity serves as the lifeblood of any business, much like the supplies that keep your crew well-fed and equipped for the journey ahead. Just as a skilled captain meticulously manages and conserves their supplies, effective cash management acts as the guiding compass that ensures the maintenance and enhancement of liquidity. In this article, we will delve into various strategies and techniques that can be employed to bolster liquidity through efficient cash management, enabling your business to thrive in the face of challenges and seize opportunities on the horizon.
Why is it Important to Improve Liquidity?
Liquidity, in business, means the ability to pay when due. A situation contrary to this where a company is not able to meet its liability can be termed ‘insolvency’. Liquidity and insolvency are on the same number line but on two opposite ends. Therefore, it is in the business’s best interest to keep the Liquidity-Insolvency indicator on the side of liquidity. Excess of everything is bad. The result of higher liquidity is idle funds and the consequence is unnecessary interest cost. All we need is a balance because low liquidity poses the risk of insolvency, while too high liquidity indicates inefficient cash management.
- Why is it Important to Improve Liquidity?
- You Can’t Improve if You Can’t Measure
- How to Improve Liquidity by Effective Cash Management?
- Cash Forecasting
- Managing Receivables
- Managing Payables
- Inventory Management
- Cash Flow Management
- Improve Sales of High Margin Products / Reduce or Eliminate Loss-Making Products
- Invoicing Discipline
- Minimize Cash Flow Risk by Availing of Insurance
- Current Assets Financed through Long Term Sources
- External Services for Improving Liquidity
You Can’t Improve if You Can’t Measure
The best tool to measure the liquidity position of a company is liquidity ratios such as the current ratio, acid-test ratio, or quick ratio. Monitoring and keeping these ratios optimized will improve the company’s liquidity position. Additionally, note that an appropriate liquidity ratio is one of the eligibility requirements for short-term loans.
How to Improve Liquidity by Effective Cash Management?
- Importance of accurate cash forecasting: Accurate cash forecasting allows companies to anticipate their future cash inflows and outflows. This helps in identifying potential cash shortages or surpluses, enabling proactive decision-making.
- Techniques for cash forecasting: Companies can use various techniques such as historical data analysis, market research, sales projections, and industry trends to forecast their cash flows. Additionally, cash flow software or financial modeling tools can assist in generating accurate cash forecasts.
- Implementing credit policies: Establishing clear credit terms, credit limits, and credit evaluation processes can ensure that customers pay on time, reducing the risk of cash flow issues.
- Monitoring and reducing overdue payments: Regularly monitoring accounts receivable and taking proactive steps to follow up on overdue payments can help improve cash inflows.
- Offering discounts for early payments: Incentivizing customers to pay earlier through discounts or other incentives can accelerate cash collections.
- Negotiating favorable payment terms with suppliers: Negotiating longer payment terms or discounts for early payments with suppliers can help extend the company’s cash conversion cycle.
- Taking advantage of trade credit: Utilizing trade credit options provided by suppliers can effectively manage cash outflows by delaying payment obligations.
- Streamlining the accounts payable process: Implementing efficient accounts payable processes, including automated invoice processing and payment scheduling, can improve cash flow management.
- Analyzing inventory turnover ratio: Monitoring the inventory turnover ratio helps assess how quickly inventory is being sold and replenished. A higher turnover ratio indicates efficient inventory management and reduces the risk of excess inventory tying up cash.
- Implementing just-in-time (JIT) inventory system: Adopting a JIT system minimizes inventory holding costs by receiving goods from suppliers only when needed, reducing the amount of cash tied up in inventory.
- Identifying slow-moving or obsolete inventory: Regularly reviewing inventory levels and identifying slow-moving or obsolete items allows companies to take necessary actions such as discounting or liquidating them to free up cash.
- Establishing effective inventory control policies: Implementing proper inventory control measures such as setting reorder points, safety stock levels, and conducting regular stock audits helps optimize inventory levels and prevent overstocking or stockouts.
Cash Flow Management
- Accelerating cash inflows:
- Offering discounts for early payments from customers: Encouraging customers to make early payments by offering discounts can improve cash flow by reducing the accounts receivable collection period.
- Implementing efficient invoicing and collections processes: Streamlining the invoicing and collections processes, including issuing invoices promptly and following up on overdue payments, helps expedite cash inflows.
- Sell-off Unproductive Assets: Sell the assets which are lying unused and for which there are no plans to use.
- Cash sweep: Use cash sweep accounts to earn interest on idle funds.
- Managing cash outflows:
- Negotiating favorable payment terms with vendors: Negotiating longer payment terms or payment schedules with vendors can provide more flexibility in managing cash outflows.
- Prioritizing payments to essential suppliers: Identifying critical suppliers and ensuring timely payments to maintain good relationships and avoid disruptions in the supply chain.
- Evaluating capital expenditures carefully: Assessing the necessity and potential return on investment for capital expenditures before committing cash can help prioritize and manage cash outflows effectively.
Remember, implementing these strategies requires careful analysis and customization based on the specific needs and circumstances of each company.
Enhancing liquidity is a critical aspect of financial management. While conventional methods are well-known to finance professionals and entrepreneurs, exploring innovative approaches can lead to greater financial stability.
Discussed above were the common ways to improve liquidity which are directly related to cash. The following are some innovative ways to improve liquidity:
Improve Sales of High Margin Products / Reduce or Eliminate Loss-Making Products
Selling high-margin products generates more revenue and profits, increasing cash flow, which can then be used to meet financial obligations and invest in growth opportunities. Eliminating loss-making products reduces expenses and frees up cash to fund operations, pay off debts, or invest in higher-profit margin products or services.
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 on creating credit notes, resolving billing issues, etc.
Minimize Cash Flow Risk by Availing of 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 costs, 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.
In conclusion, effective cash management is crucial for maintaining liquidity and achieving an optimal level of working capital. By implementing the mentioned methods and techniques, businesses can enhance their liquidity position and ensure a smooth working capital cycle.