Liquidity management is crucial for the financial health and stability of small businesses (or a business of any size) and impacts the ultimate success of these businesses. It refers to the process of effectively managing a company’s cash flow to ensure that it has enough cash on hand to meet its short-term financial obligations while also optimizing the use of surplus cash to grow this cash for a rainy day or to grow the business. Banks also face new liquidity challenges as they guard our money, facilitate transactions, and provide the basis of sound financial stability that businesses need for their own liquidity management. But in the current day, banks and other types of businesses face a new problem that requires all of their focus: liquidity management.
Introduction to liquidity management
Simply put, liquidity refers to a business’s capacity to fulfill its financial commitments when they become due without suffering intolerable losses. It is the lifeblood that allows banks to distribute cash, finance loans, and keep everything running smoothly. Other businesses require effective liquidity management to meet their daily financial needs such as payroll, inventory payments, and other operating expense obligations. Effective liquidity management has become more important to a business’s survival strategy as a result of the growing interconnectedness of the world’s markets.
While some agencies, like the FDIC, focus on liquidity management from the perspective of banking, liquidity management requires careful attention from all businesses regardless of industry. Elements of liquidity management include:
- projecting future financial obligations to ensure sufficient funds on hand
- managing cash flow to reduce the need for borrowing or incurring financial penalties for late payments
- ensuring sufficient cash to fund necessary expenditures so the business can function without interruption
- managing risk to reduce the potential for financial expense
- contingency planning to avoid unexpected loss or expenses
New challenge for liquidity management
The changing environment
The financial environment changed dramatically in recent years. The pandemic and the supply chain challenges in the aftermath caused serious stresses for businesses and impacted all facets of their operation to strain liquidity. Changes in interest rates, legal changes, and technological developments all had their impact, creating additional challenges. For businesses, navigating this dynamic environment has generated a complex web of difficulties. Maintaining appropriate liquidity levels while maximizing profitability has turned into a risky balancing act.
The impact of interest rates on the economy
Similar to the tides, interest rates ebb and flow, forming the financial coastline. Rates are adjusted by central banks all around the globe to combat inflation while ensuring a low impact on economic growth. The liquidity situations of businesses are directly impacted by these rate changes. A sharp rise in borrowing costs for banks due to a rate increase might possibly limit their liquidity.
And, you don’t have to be a financial guru to see that recent efforts by the Federal Reserve to curb inflation resulted in severe financial stress for businesses by increasing the cost of borrowing for these businesses. Increased borrowing rates also impact businesses as consumers cut spending faced with increased borrowing costs (which is why increasing interest rates helps cool the economy to reduce inflation). For instance, the mortgage rate is now over 7%, the highest it’s been since 2002, which makes home buying more costly and reduces the demand among prospective homeowners.
The evolution of technology
Technology gave liquidity management a dose of both promise and difficulty as the globe rushes toward a digital future. On the one hand, clients may now shift money and make payments more easily thanks to digital platforms. On the other side, they have quickened the velocity of transactions, necessitating that businesses, especially banks, must make sure they have enough liquidity to support this quick transfer of money. For businesses, electronic collaborations between members of the supply chain work to speed up orders and payments through the system, which helps businesses get new orders and arrange for raw materials from suppliers but also speeds up demands for payment for these orders.
Following the financial crisis of 2008, regulatory authorities are now playing a symphony of rules and regulations that banks must abide by. These laws outline the minimal liquidity buffers that banks must maintain, ensuring that they have sufficient easily accessible assets to withstand crises. For instance, the Basel III framework mandates that banks maintain a Liquidity Coverage Ratio (LCR) in order to satisfy their short-term liquidity demands. Liquidity management is a crucial component of a bank’s compliance activities since non-compliance may lead to penalties and reputational harm.
The data conundrum
Businesses are awash with data, which is the new oil. Making meaningful inferences from this data in order to make defensible judgments about liquidity management is the difficult part. Businesses may simulate different scenarios, stress test their liquidity levels, and improve their financing plans with the use of advanced data analytics technologies.
Unfortunately, guessing wrong has serious consequences. For instance, the failure of several banks in high-tech areas of the country faced bankruptcy when they failed to anticipate rising interest rates and were locked into low-interest government bonds at a time when the revenue didn’t exceed the cost of borrowing.
The future: getting through the liquidity maze
A multifaceted strategy is crucial as businesses struggle with this new liquidity scenario.
- Cash flow forecasting: Create a detailed cash flow forecast that estimates your expected inflows and outflows over a specific period, such as a month or a quarter. This helps you anticipate potential cash shortages and plan accordingly.
- Monitor accounts receivable: Keep a close eye on your accounts receivable. Ensure your customers pay on time and consider implementing a system to follow up on overdue payments. The cost of factoring these receivables now makes this strategy less attractive.
- Manage accounts payable: Negotiate favorable payment terms with your suppliers while maintaining good relationships. This can give you more time to pay bills and manage your cash flow effectively. Commonly, suppliers offer products on a 2/10 net 30 basis which means you can obtain a discount of 2% if you pay for the product within 10 days. You should figure taking advantage of these discounts into your cash flow statements to reduce costs. If you own a new business, suppliers may require pre-payment for inventory. Work with these suppliers and pay your bills on time to earn their trust so they offer more favorable payment terms.
- Working capital management: Efficiently manage your working capital by optimizing your inventory levels, managing accounts receivable and accounts payable, and controlling expenses. I once consulted with a manufacturer that rushed invoicing to show a higher monthly income only to pay overtime to workers to ensure prompt completion of the products already invoiced which meant higher costs for a paper profit. That just makes no sense.
- Emergency fund: Maintain an emergency fund to cover unexpected expenses or cash flow gaps. This fund acts as a buffer during challenging times. It’s ok to invest these funds in short-term instruments but never put them into bonds or other long-term investments. The idea is to have cash on hand quickly for emergencies.
- Short-term financing: Explore short-term financing options like lines of credit, business credit cards, or invoice financing to bridge temporary gaps in cash flow. If you set these up before they’re needed, you get them at the lowest cost possible.
- Expense control: Regularly review and assess your business expenses. Identify areas where you can cut costs without compromising the quality of your products or services. For instance, do you need all the space you’re paying for? Do you need a high-priced office space or would a co-working space or other low-cost alternative work just as well? Do you need full-time employees or could you solve your needs with gig workers, other part-time staff, or third-party outsourcing, which offers good quality with lower costs (see below)? This is the classic make versus buy decision that favors buying until your need exceeds some threshold. There are lots of ways to make your cash stretch so don’t make assumptions about the way things are done that tie up your cash when you don’t need to.
- Inventory management: Avoid overstocking inventory, as it ties up cash. Utilize just-in-time inventory practices to reduce storage costs and improve cash flow. Also, maximize your storage to require the least space possible while improving your efficiency in picking and pulling to reduce those shipping costs. For instance, stories abound of the military ordering inventory they already stocked because they didn’t know where the items were located. RFID tracking was developed to solve the twin problems of maximizing storage efficiency and quickly identifying where items are stored.
- Flexible payment options: Offer flexible payment options to customers, such as installment plans or discounts for early payment, to encourage timely payments while encouraging increased purchases among consumers who are also strapped for cash.
- Seasonal variations: If your business experiences seasonal fluctuations, plan ahead and save during peak seasons to cover expenses during slower periods.
- Debt management: If you have existing debts, manage them strategically. Refinance or consolidate high-interest loans to reduce interest costs.
- Invest surplus cash: Instead of letting excess cash sit idle, consider short-term investments that offer better returns than traditional savings accounts. Just be sure to choose safe and liquid investment options.
- Regular financial analysis: Regularly analyze your financial statements frequently to identify trends, potential issues, and opportunities for improvement. This can help you make informed decisions about your liquidity management strategy. Utilize computerized solutions so you can identify financial problems, excess cash, and project future needs on an ongoing basis.
- Scenario planning: Develop various financial scenarios to understand how different situations could impact your cash flow. This can help you prepare for both positive and negative changes.
- Technology solutions: Use accounting and financial management software to streamline cash flow tracking, invoicing, and financial reporting.
For businesses, managing liquidity has become a new frontier that requires striking a careful balance between legal compliance, technological integration, and long-term planning. Banks must adapt and innovate as the financial environment changes in order to fulfill their duties, protect financial stability, and face future liquidity issues. Only those institutions that excel at this complex dance of liquidity management will prosper in the dynamic financial environment.
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