Cash and Liquidity Management - Importance & Types (2024)

13 June, 2023

20 min

Cash management manages a business’s short-term cash position, whereas liquidity management focuses on managing its cash flows in the long term through cash flow planning and forecasting.

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 contrary, 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.

Liquidity Management Techniques

There are typically two liquidity management techniques that companies use:

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

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.

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.

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

Main Pillars in Cash and Liquidity Management

1. Cash flow monitoring and analysis: The first pillar in effective cash and liquidity management is to monitor and analyze the organization’s cash flows.

• 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.
• 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: 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.

• 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.

• 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: 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.

• 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.
• 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: 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: The fourth pillar involves evaluating and mitigating risks that impact a company’s liquidity.

• Process:

• 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: 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.

• Process:

1. Extract liquidity from the operating cycleand reduce cash conversion cycle by:

1.1. Analyzing inventory turnover rates, identifying slow-moving or obsolete items, and implementing inventory control measures

1.2. Establishing credit policies, monitoring and collecting outstanding receivables promptly, and considering offering incentives for early payments.

1.3. Negotiating favorable payment terms with suppliers, taking advantage of discounts for early payments, and optimizing payment schedules.

1.4. Assess the suitable cash pooling structure based on your company’s needs and identify the central cash pool account and subsidiary accounts.

1.5. Establish pooling agreements that define the terms and conditions of the pooling arrangement, including allocation of funds and interest calculations.

1.6. Enhance returns by investing in instruments such as money market funds, corporate bonds, certificates of deposit, and dividend-paying stocks.

• 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: 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.

HighRadius’ Cash Management Solution offers the following benefits to enable you to execute industry best practices for cash and liquidity management:

1. Integrated data aggregation: Obtain a comprehensive, real-time overview of cash balances through automated financial data integration from disparate ERPs, financial systems, and bank accounts.
2. Continuous global cash visibility: Access consolidated bank balance information in a single interface, tailor views according to your preferences, and make transactions with a single click.
3. Automated cash reconciliation: Achieve error-free reconciliation of current-day or previous-day bank statements with cash transactions to find and resolve exceptions.

4. Rolling cash positioning: Gain valuable insights into short-term liquidity requirements using customizable cash position worksheets.

5. Centralized bank account administration: Manages a consolidated record of all bank account details and authorized signatories, simplifying bulk import, editing, and updating as needed.
6. Automated financial instrument tracking: Populate debt and investment settlement instructions and generate cash flows while incorporating them into cash positions.
7. Daily cash reporting: Instill credibility in internal and external stakeholders by creating error-free and real-time cash reports in multiple formats.

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.

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.

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