Cash Liquidity Management Techniques for Improving Your Liquidity Ratio
Organizations may suddenly need to cover debts or pay vendors for goods or services. To deal with these costs, your company needs to use proper cash liquidity management techniques.
Liquidity management is an essential part of finance and accounting for any business. It refers to the availability of cash for short-term transactions or investments.
With liquidity planning, organizations balance and monitor liquid assets to meet short-term cash obligations. Here is what you should know about liquidity management and the liquidity ratio.
What Is Liquidity Management?
Liquidity management is the process of balancing liquidity ratios, helping to maintain a positive outlook for potential investors or lenders.
The liquidity ratio is the available liquid assets compared to debts. If you have limited cash available, you may struggle to meet your financial obligations. This hurts an organization’s image and may even result in the loss of clients or investment opportunities.
Current Ratio Versus Quick Ratio
Most banks and financial institutions use the “current ratio” for measuring liquidity. With this method, you divide current assets by current short-term liabilities. A higher ratio means that you have more liquidity.
The “quick ratio” provides another method for analyzing a company’s overall financial health. With the quick ratio, you measure liquidity by dividing short-term assets by short-term obligations.
Short-term assets include cash and cash equivalents plus marketable securities and accounts receivable due within the next 90 days. Current liabilities include debts due within the next 12 months.
A ratio of 1:1 means that a company has the liquid assets needed to meet short-term financial obligations. This method removes inventory from the equation and provides a more conservative estimate.
No matter the ratio you use, your liquidity ratio should show lenders or investors that your business remains a suitable candidate for a loan or investment.
If you need to obtain a higher ratio, use the following cash liquidity management techniques to increase liquid assets and limit short-term liabilities.
Streamline Billing to Receive Prompt Payments
For many businesses, cash flow comes from billing. Simplifying your collection methods can lead to faster payments from clients, resulting in more liquidity for your business. Submitting invoices early also helps with collections.
Retail businesses and shops are exceptions. These businesses tend to deal with up-front cash payments instead of invoices. However, they still benefit from streamlined payment systems.
Streamlining cash collection methods helps all types of organizations obtain accounts receivable in a timely manner. This provides predictable liquid assets for helping balance the liquidity management ratio.
Negotiate Longer Payment Cycles with Vendors
Along with accounts receivable, accounts payable provides an opportunity to increase liquidity. Negotiating a longer period between payments allows your organization to hold on to cash longer.
Instead of paying a vendor monthly, try paying quarterly or annually. With longer terms, you may not need to move assets around as quickly.
In many cases, larger up-front payments covering a longer period result in savings. Paying up front for the year could lead to lower overhead costs and fewer short-term liabilities.
Reduce Overhead Costs to Increase Profitability
With less overhead, you have more cash available. Besides cutting costs through longer payment periods, you may find additional ways to limit financial obligations.
Review all expenses to look for opportunities to reduce operating costs. You may be able to negotiate lower rental costs for commercial leases or find cheaper contractors for completing indirect labor.
Sell Unproductive Assets to Increase Available Cash
Equipment, machinery, buildings, and vehicles that do not generate income end up costing you more money. Upkeep and repairs eat into your cash reserves.
To increase liquidity, get rid of these unproductive assets. Sell off any assets that your organization no longer needs. Unfortunately, you may struggle to find buyers for some items. Disposing of them for any value still provides a way to reduce unnecessary costs and burdens while freeing up a small amount of cash.
Use Long-Term Debt for Investments or Funding
When obtaining new debt, opt for long-term loans instead of short-term ones. With long-term debt, you often owe less interest and smaller monthly payments.
With lower payments, your short-term liabilities decrease, improving your liquidity ratio. You may even use long-term debt to wipe out some of your short-term debts, consolidating obligations to reduce the number of repayments that you need to make each month.
Instead of consolidating debt, consider paying off liabilities whenever possible. As with personal debt, it helps to start with the debt with the highest interest rates, which is often your short-term loans.
Pay off some of these liabilities. As liabilities are the denominator for determining your liquidity ratio, decreasing your obligations naturally improves your ratio. You may also save money by paying off debts early and avoiding extra interest over the life of the loan.
Increase the Profitability of the Company
Reducing overhead increases profitability but there are other ways to make more money. Increasing the price of products or services or tapping into a new market may help increase profits.
Increasing profitability brings in more cash flow, boosting the available liquid assets and increasing the liquidity ratio.
Why Is Cash Liquidity Management Important?
Managers, lenders, and investors use liquidity measurement ratios to determine the liquidity risk of a business. By comparing short-term liabilities and liquid assets, you can evaluate a company’s ability to meet its financial obligations and make additional investments to continue growing.
Investors or lenders may consider a business with fewer assets to liquidate a higher risk. This limits your chances of obtaining new investments or receiving approval for new funding.
With a liquidity ratio of 1:1, you have exactly enough cash available to cover your financial obligations. Ideally, the ratio should be a little higher.
Using the current ratio, most analysts recommend a ratio of 2 or 3 to 1. With the quick ratio, you should try to maintain a ratio of 2 to 1 or higher.
If you want to maintain a positive liquidity ratio, use the techniques discussed to limit liabilities and increase available cash liquidity.