Liquidity management: What businesses need to know

In order for a business to function effectively, it must have enough cash on hand to cover its short-term obligations and pay for other mission-critical expenses. Liquidity management is all about ensuring that this is true.

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Below, we take a closer look at what liquidity management is and why it's so important. We also discuss the different types of liquidity, the different ways you might assess it, and provide a number of best practices you can follow to set your business up for long-term success.

What is liquidity management?

Liquidity management refers to the various processes that a business undertakes to ensure that it always has enough working capital available to pay for short-term obligations, debts, and other liabilities. 

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The different processes involved in liquidity management often include:

• Monitoring cash reserves: How much cash or liquid assets does your business currently have on hand? How do these reserves fluctuate from day to day, week to week, month to month, or quarter to quarter? Are they high enough to cover your current liabilities?
• Monitoring cash flow: How does money currently flow through your business, in the form of revenues and expenses? How does this compare against your historical cash flows? 
• Forecasting cash flow: What do you expect your cash flows to be in the future? If you expect outflows to be higher in the future than they are today, what steps can you take to similarly boost inflows or otherwise increase your liquidity to account for additional liabilities?
• Optimizing AR/AP: Are your accounts payable and accounts receivable processes set up in such a way as to be able to efficiently collect and disburse payments? How can you ensure that you are collecting payments on time? What steps can you take to optimize AP and AR, boost transparency, and increase efficiency? 
• Managing short-term debt: What debts and other obligations are coming due for your business in the next month, quarter, and year? How do these obligations compare against your liquid assets? What steps, if any, can your business take to reduce the impact of these debts—such as strategic refinancing, etc. 
• Managing short-term investments: What short-term investments—such as certificates of deposit (CDs), money market accounts, and bonds—does your business hold on its balance sheet that it expects to convert into cash in the next year? Are these performing as expected, or do adjustments need to be made to your holdings?
• Securing and assessing credit: What lines of credit are available to your business, should they become necessary to cover a short-term gap in cash flow? Are there steps that you can take to secure additional funding, lower your interest rates, or to boost your credit limits?

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At the same time, it’s important to recognize that liquidity management is not simply about stockpiling cash in order to have as much liquidity as possible. Going that route might mean cash is sitting on the sidelines that could be put to better use growing your business. Instead, proper liquidity management is about ensuring that your company has a responsible amount of liquidity—not too little but also not too much. 

Why is liquidity management important?

If your business doesn’t have enough liquid assets to meet its short-term obligations, it could grind your operations to a halt, making it impossible to pay your employees, purchase inventory or supplies, and function in a meaningful way. 

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Proper liquidity management empowers you to always have a clear sense of your company’s assets and liabilities. Likewise, it gives you the opportunity to identify threats to your liquidity so that you can take steps to mitigate them before they become a larger issue. 

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It should be noted that liquidity isn’t just important to business owners and managers. Investors will often evaluate a company’s liquidity before making an investment, as a part of their risk management processes. Likewise, banks, financial institutions, and other lenders consider liquidity before agreeing to originate a loan or extend a line of credit to a business. Liquidity management can, therefore, help your business in attracting lenders and investors, should that be important to you.

What are the types of liquidity?

When different people talk about liquidity, it’s possible that they might actually be talking about different things. That’s because there are actually multiple different types of liquidity, each of which is typically used in different contexts and by different people. 

Accounting liquidity

Accounting liquidity refers to how easy it would be for a company to meet its current liabilities and short-term obligations (payroll, inventory costs, accounts payable, etc.) using their liquid assets. Businesses with a high degree of accounting liquidity would have an easier time meeting their obligations than businesses with low accounting liquidity.

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Businesses track and calculate their accounting liquidity in order to manage financial risk and understand their organization’s solvency. Investors and analysts, on the other hand, look to a company’s accounting liquidity to determine if they should make an investment. 

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This type of liquidity is the one that is typically most relevant and important to businesses, though asset liquidity and market liquidity can also be important. 

Asset liquidity

Asset liquidity refers to how easy it would be to convert an asset into cash. 

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Cash is itself already highly liquid, as are cash equivalents which can be quickly converted into cash. Investments like stocks and bonds, which a company might hold, are also typically considered highly liquid, so long as there is adequate market liquidity (see below). 

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A company’s inventory may be considered liquid or illiquid, depending on factors like demand and the company’s sales cycle. Other assets, like real estate, equipment, and intellectual property (IP) is typically considered illiquid, as it can take time to sell it and convert it into cash if the need arises.

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In order to truly understand how solvent they are, businesses need to have a clear sense of the liquidity of each asset on their balance sheets. 

Market liquidity

In order to convert an asset into cash, a market needs to exist for that asset. Examples include the stock market, bond market, real estate market, etc. Market liquidity refers to a given market’s ability to facilitate the buying and selling of a particular asset. 

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Market liquidity can be fairly complex. That being said, a highly liquid market will typically have many buyers and sellers, low transaction costs, and high price transparency—all of which make it easier to sell an asset and convert it into cash. 

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How liquid a given market is will impact an asset’s liquidity, so asset liquidity and market liquidity are often discussed alongside each other. 

How to assess liquidity

You can assess your company’s liquidity position in a number of ways, including by calculating one or multiple liquidity ratios. These are financial metrics that compare your current assets to your current liabilities. Three common liquidity ratios you may leverage in this way include your business’s:

• Current ratio: The current ratio assesses your business’s ability to cover its current liabilities using its current assets, and is typically the simplest liquidity ratio to calculate. Current assets include cash and everything else your business owns which could be converted into cash, such as securities, accounts receivable, and inventory. To calculate your business’s current ratio, divide your current assets by its current liabilities. 
• Quick ratio: The quick ratio assesses your business’s ability to pay for its current liabilities using assets that can be quickly converted into cash. It typically includes cash and equivalents, accounts receivable, and securities, but disregards inventory (which might not be readily converted into cash). To calculate your company’s quick ratio, just take your current assets and subtract the value of your inventory. Then divide by your current liabilities. 
• Cash ratio: The cash ratio assesses your business’s ability to cover short-term liabilities using only its most liquid of assets—cash and cash equivalents. To calculate your company’s cash ratio, just divide your cash and cash equivalents by your current liabilities. 

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Factors that impact liquidity risk

Liquidity risk (i.e., the risk that your company will become illiquid) is not static. It can and does vary over time based on a number of different factors, each of which affects your liquidity position and overall financial health. Some of the most important factors affecting your working capital in this way include:

• Seasonality: If your business experiences periods of high demand and periods of low demand throughout the year—as many do around the holiday season—it creates peaks and troughs in your cash flow. Failure to account for the low periods, particularly, risks creating a liquidity crunch. 
• Inventory: When your business holds more inventory than it needs at any given time, it is essentially locking up capital in the form of product. To gain access to that capital, you’ll need to sell the inventory. For businesses with long sales cycles or lead times, inventory mismanagement can lead to significant liquidity concerns. 
• Unpaid invoices: If your business is not disciplined in invoicing customers or chasing delinquent payments owed, it can cause cash flow problems that ultimately affect your liquidity. 
• Unmanaged POs: Likewise, if your business has many expenses or bills come due at the same time, it could mean too much money is leaving your coffers at once. 

Liquidity management strategies and best practices

The good news? There are many strategies you can implement to set your business up for more successful liquidity management. Below are some best practices to keep in mind as you think about your own processes:

Keep inventory levels reasonable

As noted above, inventory is illiquid compared to cash, especially if your business has a long sales cycle. While you don’t want to run too low on inventory, components, or supplies, it’s important not to dramatically overstock either. 

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Implementing just-in-time (JIT) inventory management, where your business receives inventory at the exact moment that it’s required, can help you maintain a delicate balance between too little, too much, and just the right level of inventory while preserving liquidity.

Optimize procurement and supply chain management

If you hope to implement a just-in-time inventory management strategy, it’s important that you are confident that your procurement team and supply chain can quickly deliver product and components when they are needed. Without these capabilities, it will be difficult, if not impossible, to keep inventory low in order to manage your company’s liquidity. 

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With this in mind, take a look at your procurement management processes and ensure that they are as efficient and effective as possible. Evaluate your supply chain for resiliency until you are confident that it can effectively support a JIT strategy.

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Prioritize payment

The faster your business is able to collect payment from customers and clients, the easier it will be to forecast and manage cash flow. Taking steps to facilitate quicker payment (and fewer delinquencies) will lead to a stronger liquidity position for your business overall. 

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Just a handful of steps you can take to strengthen your accounts receivable process include:

• Sending invoices to customers immediately upon delivery of product or services, or once you meet the terms of your agreement
• Encourage customers to prepay for their order (for example, by offering a small discount) so that you get payment up front and can immediately deploy the cash flow elsewhere 
• Provide customers with multiple ways to pay—including by ACH or other quick means vs a physical check that could take days or weeks to be delivered and deposited

Negotiate flexible payment terms

When it comes to liquidity, it’s just as important to manage your outflows as it is your inflows. With this in mind, when you make a purchase from a vendor or supplier, consider negotiating your payment terms in such a way as to improve your liquidity. 

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If you’re worried about too much cash flowing out of your business at once, for example, you might try negotiating a longer payment term, or asking if it is possible to make a number of smaller payments over time instead of a single large payment all at once. Or, you could go the opposite direction: Offering prepayment or early payment in exchange for a discount. 

Track and manage expenses

The better you are at anticipating business expenses, the easier it will be to forecast outflows and cash flow. By tracking your business expenses, you provide yourself with the data you need to make these decisions. 

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First, tracking expenses empowers you to understand where your company is currently spending its money. With enough time and data, it’s possible to look for trends in spending—making your budgets more accurate. Beyond this, expense management makes it possible to identify opportunities to reduce costs, helping your business become more disciplined in its spending to preserve working capital. 

Ramp helps you automate many of these steps

Adequately managing your company’s liquidity requires diligence, agility, and attention to detail. If you’re routinely slow to close the books or you see a lot of mistakes—whether in a purchase order, invoice, expense report, or vendor contract—there’s a risk that you are working off of an inaccurate picture of your business’s liquidity position. That might be a recipe for disaster. 

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With Ramp’s all-in-one expense management platform, you can automate many of the most time-consuming or error-prone parts of the process—from procurement to expense management to accounts payable, reporting and more—in order to optimize liquidity management.