Liquidity management

Liquidity management
Primary topic
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Methods and techniques

Financial liquidity - it is the company's ability to pay its current liabilities (payable up to one year) and to buy all kinds of goods and services. It depends on the liquidity whether, on time, pay is paid to employees, obligations to suppliers for goods and services and whether the company is able to buy goods and services when they are needed to satisfy their own needs.

It is considered that financial liquidity is just as important as the company's profit. If the company had a profit, but it was not able to pay short-term liabilities, it was forced to declare bankruptcy. Lack of liquidity does not allow the company to continue to prosper, as there are no funds to pay for contracts.

I will mainly use financial liquidity managers to manage the company, as well as side effects when granting short-term loans.

Information sources for liquidity management

The following sources of information can be distinguished, which are basic for managing the company's financial liquidity:

  • Balance
  • Profit and Loss Account
  • Cash Flow
  • Liquidity shots

We consider financial liquidity in two aspects:

  • in static terms - it is a reference to a specific moment, eg until the balance sheet date, using the basic financial statements: balance sheet, profit and loss account and financial liquidity ratios, which will be discussed later.
  • in dynamic terms - this is a reference to a specific period using the cash flow statement

Measurement of financial liquidity

The following indicators are used to assess financial liquidity:

  • Current financial liquidity
  • Accelerated financial liquidity (fast indicator)
  • Cash
  • Instant financial liquidity

The above indicators can be calculated based on:

  • Data expressing the state of the phenomenon at the beginning and end of the reporting period; differences between such calculated indicators show changes in the examined phenomenon, which are the result of economic decisions made throughout the reporting period,
  • Medium sizes; they are determined by dividing by two sums of stocks at the beginning and at the end of the reporting period.

Financial liquidity ratios

Current liquidity ratio

Current liquidity ratio = Current assets ÷ Current liabilities

This ratio informs how many times current assets (easily convertible into cash) cover current liabilities (short-term liabilities). It is assumed that the satisfactory level of this indicator ranges from 1.2-2.0. So the amount of current assets should be about twice as large as current liabilities. Then you can talk about maintaining financial balance. The low level of the indicator means that the company has no cash resources to finance its current liabilities. The high ratio indicates a smaller share of short-term liabilities in financing current operations.

Because inventories are placed in current assets whose liquidity is delayed in relation to other assets, we apply a different financial liquidity rate indicator.

Accelerated financial liquidity indicator (fast indicator)

Fast index = Current assets-inventories ÷ Current liabilities

This ratio informs how many times the liquidity assets (without inventories) cover current liabilities. It is believed that this indicator at 1.0 is sufficient to cover the current liabilities by the company, a small difference between these indicators is desirable. If we are dealing with a high current ratio and a low rate of fast, then the company maintains too high stocks, in which SA has frozen funds. But such a large stock strategy is effective as a barrier against inflation. However, when the current ratio is low and the high rate indicator means unproductive cash management in the banking markets, in the form of receivables, etc.

Cash indicator

Cash ratio = Short-term investments ÷ Current liabilities

This ratio informs what part of the liabilities can be repaid on the basis of assets not related to the operating process, in the form of cash or short-term investments or its substitutes. The meter of this indicator takes into account assets whose ability to settle liabilities is the fastest. The total lack of cash may lead to losses caused by the lack of concluding transactions / using market opportunities, and the excess, to the costs of lost opportunities.

Instant financial liquidity rate

Immediate liquidity ratio = Cash and other cash assets ÷ Current liabilities with a maturity of up to 3 months

This ratio is the ratio of cash and their substitutes, from which cash can be recovered up to 3 months, to liabilities immediately due, i.e. those whose maturity falls within the next 3 months. There is no standard developed for the amount of this indicator. The assessment consists in comparing its value over time.

Factors shaping financial liquidity

The factors affecting financial liquidity include:

  • Structure of current assets,
  • Liquidity of current assets,
  • The length of the operational cycle from the specifics of the industry,
  • The structure of asset sources, mainly the ownership structure (share of equity in total capital, the level of corporate debt),

Debt structure (share of current liabilities in total debt):

  • Material and subjective structure of current liabilities,
  • Time structure of current liabilities (timely, overdue).
  • The effects of loss of financial liquidity in the enterprise

Loss of financial liquidity has many negative effects on the company:

  • Deterioration of the market position compared to competitors - on the supply side as well as on the sales / distribution side of finished products,
  • Loss of flexibility in making decisions - it also involves the loss of the ability to manage the financial result,
  • Deterioration of financial results due to increased operating and financial costs, decrease in sales,
  • Limiting the company's development - the company's ability to service current debts and to incur new ones are lost