Liquidity management is a cornerstone of every treasury and finance department. Those who overlook a firm’s access to cash do so at their peril, as has been witnessed so many times in the past.
In essence, liquidity management is the basic concept of the access to readily available cash in order to fund short-term investments, cover debts, and pay for goods and services.
Liquidity planning is crucial, and involves finance and treasury managers’ ability to look to the company’s balance sheet and convert funds that are tied up in longer-term projects into cash for the firm to use in its day to day operations.
In order to keep a regular grasp of the firm’s liquidity risk, managers will monitor the liquidity ratio – in which firms will compare their most liquid assets (those that can be converted into cash easily and quickly), with short term liabilities, or near-term debt obligations.
The importance of liquidity management cannot be understated. Liquidity risk, which treasurers and finance department managers constantly attempt to downplay, can lead to a variety of problems and pull a company into ill health.
Should the firm find itself unable to meet short term cash obligations, or cash equivalent obligations as set out in contractual terms with depositors and borrowers, it may find itself in a position in which it must sell illiquid assets quickly – which could lead to a situation in which it may be forced to accept less than those assets’ fair value. Avoiding such as situation is key to successful liquidity risk management.
There are a variety of different techniques applied by firms across the globe that help mitigate liquidity risks and assist with liquidity planning:
Receivables management – the strict approach to ensuring that clients and customers maintain payments in a timely and orderly fashion – is crucial.
Generally speaking, clients will pay in such a way that the firm will be able to use the funds to meet short term obligations. However, with many contracts, deals and invoices stipulating a required time period within which the client must meet their payment obligations, monitoring each client’s outstanding payments and ability to pay themselves is fundamental to the smooth running of the business.
This element of receivables management comes under the umbrella of cash forecasting – a key concept in good liquidity management. A good cash flow forecast accurately predicts the cash inflows and outflows expected over a pre-defined period in the future, normally twelve months.
It includes projected income and expenses, and is informed by the previous period’s accounts. Being able to accurately assess when a company will have access. Within that, payables management is another cornerstone of good liquidity management. This is the maintenance of the firm’s outstanding liabilities and debts to third parties – any goods or services supplied to the firm – made on credit.
Generally speaking, a firm will wait until the very last minute to fulfil these obligations, in order to maintain cash in the event that something more urgent will require funding. Depending on the size of the debts within the context of the company, firms often prefer to have outstanding debts and cash to be able to pay them, rather than neither.
Another tool employed by firms to manage liquidity risks is netting portfolio management techniques, which allow a firm to consolidate debt obligations.
This is the process whereby a company will net third-party invoices, more usually applied when the firm has multiple outstanding invoices from the same vendor, and agree terms by which the total outstanding amount will be paid on a certain date. This can provide the firm with a single payment rather than a number of instances in which it must dip into its cash reserves.
There were many lessons learned from the financial crisis, but perhaps the most striking was that banks and larger financial services had run up huge amounts of debt, and were unable to meet their short term obligations should a shock to the market occur.
“There were many lessons learned from the financial crisis, but perhaps the most striking was that banks and larger financial services had run up huge amounts of debt, and were unable to meet their short term obligations should a shock to the market occur.”
With the market pressure that hit financial markets in 2008 and the years that followed, regulators and politicians across the world pushed for better liquidity management, more responsible liquidity planning, and better liquidity risk management.
Through a variety of regulations, established under the likes of the Dodd Frank Act in the US, the Markets in Financial Instruments Directive, now in its second incarnation in the EU, and the liquidity ratios put forth by the Basel Committee on Banking Supervision, regulatory oversight of markets has highlighted the importance of liquidity management.
In reaction, banks and financial institutions regularly perform quick ratios – or the acid test ratio, in which current assets (less stocks) are divided by current liabilities, in order to assess the ability of the firm to meet short term obligations and each regulator’s requirements.
But liquidity management is far from straightforward and brings with it many challenges that treasury and finance teams must constantly be aware of. While planning for the year ahead, managers are wary that firms cash inflows can be unpredictable.
Risks such as counterparty insolvency risk play a part in assessing the business capabilities of third parties. Should a third party go bust, it may be a difficult and time-consuming process for the firm to extract payment. That may be particularly problematic if the insolvent party is operating in a different jurisdiction. Also for those firms operating across national boundaries, cross-currency transactions can be unpredictable, with fluctuations in exchange rates making it difficult to accurately ascertain exactly how much a cash inflow or outflow will be.
“Cross-currency transactions can be unpredictable, with fluctuations in exchange rates making it difficult to accurately ascertain exactly how much a cash inflow or outflow will be.”
Companies will factor in foreign exchange risk and many will hedge to countenance different scenarios but a certain degree of unpredictability in currency markets will always exist. Further problems exist for firms operating across multiple time zones – with the added strain of chasing payments where deals are limited by time can create liquidity risk as cash inflows and outflows are expected in quick succession.
Many of the challenges of liquidity planning are centred around timing, and seasonal fluctuations in a firm’s incoming and outgoing cash flows can raise liquidity risks. Most companies – from energy and logistics firms, to banks and building societies – encounter quiet followed by busier periods, when cash inflows and outflows are imbalanced.
Considering liquidity risks and the associated liquidity planning, firms must take seasonal adjustments into account when analysing their accounting provisions.
Indeed, the prevailing business cycle could present a firm with a situation in which outflows are due prior to inflows, stretching the company’s cash reserves should finance and treasury not recognise the importance of liquidity management.
“When finance and treasury units are pulling together their various profit and loss accounts, difficulties can arise when analysing bank statements where banks report for different time periods.”
Further complexities are presented with the consolidation of and translation of data. For instance, when finance and treasury units are pulling together their various profit and loss accounts, difficulties can arise when analysing bank statements where banks report for different time periods.
This can lead to a distorted view of the amount of working capital available to the firm. Similarly, firms with a variety of operations across the globe, whether through subsidiaries or otherwise, may encounter data consolidation issues when attempting to analyse liquidity risk at the group level.
Further, conglomerates of this nature may struggle more generally in moving cash between operations in order to service different short term cash flow demands specific to each entity. Choosing the right partners, in particular banks, in order to assist in this movement of cash can be crucial to the success of the enterprise.
Other challenges exist in the supply chain of liquidity risk management, both presented by and resolved with technology. In the case of larger firms, pulling together different IT systems – some of which may be legacy systems – can be resource-heavy and result in a firm losing the ability to operate real-time liquidity management plans.
Further, modern finance and treasury professionals have come to demand the latest technology and, where partners and internal systems are out of synchronisation with what those executives have come to rely on, issues can arise where IT training is required for the use of liquidity software in mobile and application softwares.