Cash and Liquidity Management - Importance & Types (2024)

22 April, 2024

10 mins

Picture this: There’s an unexpected dip in sales or a random expense that has cropped up. You’ll be in great trouble if your cash and liquidity management strategies aren’t in place, to cover expenses like bills, payrolls, or inventory purchases. That’s where effective cash management and liquidity management come into play.

In the ever-changing world of finance and technology, smart decision-making and ensuring business resilience through financial fluctuations are crucial. Striking a healthy balance between having enough cash on hand and investing surplus funds to generate returns is essential. This not only provides peace of mind but is also a safety net whenever unexpected expenses arise.

In this blog, we will understand cash and liquidity management, its importance, and five key cash and liquidity management strategies for managing business financial health.

Cash and liquidity management primarily focuses on securing immediate operational needs by optimizing cash flows. It involves activities such as monitoring cash balances, processing payments and collections, cash forecasting, and managing risks to ensure smooth daily operations. Let us understand the factors that make cash and liquidity management extremely important:

• Improved financial health

Proper cash management ensures that the organization can meet its short-term obligations, avoiding insolvency and financial distress. It helps in improving the overall financial health of a company in the long run.

• Gain cash visibility

Efficient cash and liquidity management, helps businesses to gain cash visibility and provides a clear picture of their financial health. Cash visibility provides insights into whether there is a cash surplus or deficit, allowing stakeholders to make decisions promptly.

• Maintains operational efficiency

With sufficient liquidity, businesses can operate smoothly and ensure that the company can meet its operational expenses such as payroll, rent, and utilities without interruptions. Effective management prevents disruptions that can occur due to a lack of funds, such as delayed supplier payments or production halts.

• Enhances credibility

Reliable cash flow management builds trust with suppliers, vendors, employees, and stakeholders by ensuring timely payments and financial stability. Consistently paying suppliers and vendors on time fosters a reputation for reliability. This reliability can lead to better credit terms, discounts, and stronger partnerships.

• Optimizes cash usage

Efficient cash and liquidity management helps minimize idle cash and wisely invest surplus funds, improving overall profitability. With efficient ash management techniques, businesses can minimize cash holding while ensuring that sufficient funds are available to meet immediate needs.

• Reduces borrowing costs

Maintaining optimal cash levels can reduce the need for short-term borrowing and associated interest expenses. Consistently managing cash flows and maintaining adequate liquidity levels can improve a company’s creditworthiness. Lenders view the company as a lower risk, which can lead to lower interest rates on loans.

• Supports strategic planning

Effective liquidity management enables businesses to take advantage of growth opportunities and make strategic investments when they arise. Cash management helps prioritize projects based on available funds, ensuring that critical strategic initiatives receive the necessary investment.

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. Two of the most common types of liquidity management techniques that companies typically use are cash flow monitoring and cash flow planning. Let us understand them in detail:

Cash flow monitoring tracks current and historical cash flows to analyze the company’s cash position. The cash flow monitoring process involves the following:

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

Example of cash flow monitoring:

Let’s take an example of company XYZ and take a look at their monthly cash flow statement. This statement gives insights into each component of cash inflows and cash outflows from operating, investing, and financial activities. Stakeholders can get a clear picture of the financial health of the company through this statement and get insights on how they can optimize their cash flow.

Importance of cash flow monitoring

1. Accurately generate reports: Treasury analysts can gain a thorough understanding of cash flows to build credible, error-free reports for leadership.

2. Identifying improvement areas: Treasury managers can pinpoint efficiency and productivity gaps, focusing on areas that need improvements to achieve their goals.

3. Informed decision-making: CFOs can make informed decisions regarding cash allocation, determining when to expand or cut expenses based on cash flow trends and patterns identified.

Cash flow planning involves reviewing past budgets to make adjustments for current budgeting, forecasting cash flow for a given time, and allocating funds for various company costs.

The cash flow planning process involves:

• Prepare a cash forecast by gathering the latest actuals from banks, ERPs, and other financial systems.
• Select a cash flow model to forecast for different categories (for example using the AI model for receivables and payables and the heuristic model for payroll and taxes) and determine the time period for your forecast.
• Incorporate trends, seasonality, and scenarios into your forecasts. Ensure you base your forecasts on historical and actual data.
• Generate forecasting reports and, if needed, compare them with actuals to make adjustments.
• Add inputs from forecasts for budgeting like planned revenue, fixed costs (salaries, rent, utilities, etc.), and variable costs (supplies, travel expenses, maintenance, etc.).
• 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:

A cash flow forecast is the best example of cash flow planning. Let’s take a look at the cash flow forecasting template. By simply filling in the cash inflows and outflows, the template will provide you with the forecasted cash flow. This helps stakeholders determine if they have a cash surplus or cash deficit allowing them to make strategic decisions beforehand to avoid any financial distress.

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 identifying idle cash and using it for investing in capital, mergers and acquisitions, stocks, etc.

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

Businesses, both small and large, need effective strategies for cash and liquidity management to weather financial storms. The difference between thriving and surviving 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.

1. Cash flow monitoring and analysis

• 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.

2. Cash forecasting and planning

• Gather data from banks, ERPs, spreadsheets, FP&A, and other systems for the desired period (monthly, quarterly, or annually) and consolidate it in a single repository.
• Utilize AI modeling for complex cash flow categories such as accounts receivable (A/R) and accounts payable (A/P), heuristic modeling for cash flows such as payroll and taxes, and time series modeling for capturing seasonality, trends, and patterns.
• Consider internal and external scenarios that may impact future cash flows, such as changes in sales, expenses, industry trends, customer behavior, and regulatory and market conditions.
• Use the information obtained 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.

3. Working capital management

• Utilize 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 KPIs related to working capital management, against industry standards and targets.
• Adjust working capital management strategies as necessary based on analysis and feedback received.
• Collaborate with finance, procurement, and sales teams to ensure proper execution of working capital management initiatives.

4. Liquidity risk management process

• 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.
• Assess the likelihood of a risk occurrence and its potential impact on the organization.
• Evaluate your organization’s risk appetite and compare it with the current and potential risk exposure.
• Proactively report risks to the stakeholders and take immediate action.
• 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

5. Cash preservation and optimization

• Analyze inventory turnover rates, identify slow-moving or obsolete items, and implement 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, take advantage of discounts for early payments, and optimize 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 the 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.

Todays 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 within business units or throughout the entire company. HighRadius cloud-based treasury cash management software 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:

• Integrated data aggregation: Obtain a comprehensive, real-time overview of cash balances through 100% automated financial data integration from disparate ERPs, financial systems, and bank accounts.

• Continuous global cash visibility: 100% cash visibility through consolidated bank balance information in a single interface. Tailored views single-click transactions.

• Automated cash reconciliation: Achieve error-free cash reconciliation of current-day or previous-day bank statements with cash transactions to find and resolve exceptions.

• Centralized bank account administration: Manages a consolidated record of all bank account details and authorized signatories, simplifying bulk import, editing, and updating as needed.

• Automated financial instrument tracking: Populate debt and investment settlement instructions and generate cash flows while incorporating them into cash positions with 98% automated cash transaction tagging.

• Automated GL entries posting: Manages the GL posting rules based on the companys ERP landscape. Once the GL entries have been generated, it automatically exports the entries to be recorded in the ERP General ledger.

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 disbursem*nts, 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, disbursem*nts, pooling, and positioning.

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

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

Current ratio: Current Assets / Current Liabilities

Quick ratio: (Current Assets – Inventory) / Current Liabilities

Cash ratio: Cash and Cash Equivalents / Current Liabilities

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 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 that 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.