It’s hard for a business to function without liquidity. No matter how well you plan, there will be unforeseen challenges that pop up and affect your regular cash flow.
Businesses need a strategy where they can always meet their obligations but still be ready to adapt and change when the situation calls for it, and that’s what managing liquidity allows for.
Understanding Liquidity Management
Liquidity management involves managing your company’s cash and other liquid assets to make sure operations are moving efficiently, and that the business is financially secure. This can be divided into two distinct types: operational liquidity and strategic liquidity.
Operational liquidity refers to having enough cash or liquid assets on hand for day-to-day operations. This is all the basics of running a business, like paying bills, salaries, and unexpected expenses. On the other hand, strategic liquidity is more long-term focused. It includes funding for growth opportunities like acquisitions or investments in new technology.
A key tool in managing both these types of liquidity is cash flow forecasting. By predicting inflows (like sales revenues) and outflows (like operating costs), you can anticipate where there may be any shortfalls before they happen. By having this information readily available, you can act quickly before it becomes a big problem.
One other thing to factor in is that there are both internal and external factors that can affect your company’s liquidity position. The parts that are in your control are internal factors, and this includes things like decisions about inventory management or credit policies. On the external side, market volatility or changes to the current economic conditions could affect your liquidity.
Liquidity Management Skills
There are many skills that make managing liquidity easier for a business leader, but let’s focus on three of the most important ones: data analysis, risk management, and scenario planning. These three skills are not only very useful in a liquidity context, but they also have important uses in many other parts of running a business.
Data analysis is especially important today. One byproduct of the world becoming more digital is that huge amounts of data are frequently being created, and this can be very powerful for a business when it’s leveraged correctly. In terms of liquidity management, it can be used for things like projecting cash flow, making sure the inventory levels are optimized, and analyzing how much credit to give a specific customer.
Risk management is another key skill to have, and this involves both being able to assess risk and respond to it. Particularly if a business operates globally or sources things from outside of their country, they may find themselves with some risk to foreign exchange rates. Even if they just operate domestically, changes to interest rates can be a liquidity risk, as can counterparty risk if a supplier fails to fulfil their side of the bargain. For this reason, it can be beneficial to make use of tools through which you can check business credit for free. Tools such as this can also help you to ensure the suppliers you work with are legitimate and genuine, and, by using metrics, can indicate when your suppliers are most likely to pay any outstanding invoices. By staying on top of who you are working with, as well as their payment habits, you can minimize risks to the cash flow of your business.
One of the worst things that can happen to a business is when something hugely impactful occurs, and they’re completely blindsided by it. This is why scenario planning is so important, especially when it comes to managing liquidity.
Beyond just planning for upticks or downturns in the economy, there might be events that could disrupt the supply chain of a business, regulatory changes that impact the specific industry they’re in, or even new opportunities to expand. Businesses need to map out every scenario that could affect their liquidity and have a plan of how to respond should that scenario eventuate.
Strategies for Effective Liquidity Management
After developing the skills, you now need to put them to use as part of a strategy. There are a number of different approaches to doing this effectively, as well as different tools and technology that can help. Modern financial technology has become really powerful and has the ability to analyze data in real-time, quickly identifying the important information for business leaders to use.
Futures contracts are another tool that can help businesses manage their liquidity. They allow businesses to anticipate and potentially profit from market fluctuations, and they also provide them with an opportunity to hedge, safeguard their investments, and retain more capital.
To illustrate this, let’s talk about a financial instrument like the ES1 futures. These futures contracts are for the S&P 500, an index based on the top 500 companies in the US. Futures contracts only require a margin rather than the full contract value, meaning that businesses can bet on the future of the S&P 500 while also retaining more liquid assets. This gives them a lot more flexibility for other investments or operational expenses.
One other strategy to consider is using liquidity buffers. These are reserves or assets that can be easily converted into cash during times of financial stress. Think of them like safety nets that help ensure your business always has sufficient funds available in case of unexpected costs or market downturns.
Liquidity Management in Different Industries
Even if you have all the skills and the right strategies in place, you may find that managing liquidity plays out a little bit differently depending on the industry that you’re in. For example, those in the retail sector are more likely to experience seasonal fluctuations in sales, with peaks during holiday seasons and dips at other times throughout the year.
Businesses in the manufacturing industry face cash conversion cycles where there’s a big gap of time between purchasing raw materials and being paid for finished goods, and those in the consulting space may generally have a consistent inflow of cash, but find it hard to scale.
Every industry has nuances to how things work, meaning there is no one-size-fits-all approach. Although there are some solid general concepts around liquidity management, every business has to create a strategy that works for their specific situation.
Managing liquidity is an ongoing process. Businesses need to regularly review and update their strategies to make sure they’re doing things in the most optimal way. Being diligent in this area will create resilience in your business and save many potential headaches down the line.