What is Liquidity Management and Why is it Important in Business?
If you're like most small and medium-sized business owners when they are just starting, you could benefit
from a little clarity around some of the financial terms that seem like they mean the same thing. For
example, is a "credit" the same as an "asset"? Or could "revenue" be substituted for "cash flow" in a
sentence? Often, it may seem like these terms are interchangeable; however, it is important to
understand the differences because many of these terms or strategies can make a significant impact
when demonstrating the success of your business or when you need to apply for external funding. In the
case of liquidity and liquidity management, you'll need to understand what they are and, ultimately,
you'll need to know why liquidity management is important in business.
What is Liquidity?
Liquidity is the availability of liquid assets to your company. In other words, liquidity refers to how easily
an asset can be converted into cash without an effect on the market price or current value of the asset.
Cash is the most liquid of assets and anything tangible would be considered less liquid.
What Is Liquidity Management?
Simply put, liquidity management is a business strategy that encompasses the collective methods for
maximizing cash. To further explain: Minimizing your "outflow," or your costs associated with doing
business, is one element of liquidity management. And managing the cash flow into the business (the
inflow) is the other side of a liquidity management strategy. In other words, maintaining a liquidity
management strategy is a matter of how well a business can meet its current expenses and liabilities
using its current assets while maintaining financial stability.
Is Liquidity Management Important in Business?
Maintaining a liquidity management strategy is important to small businesses for many reasons,
including the very basic need of knowing whether you have the required cash on hand to meet your
obligations and payments in order to keep your business open and "keep the lights on."
Being able to demonstrate liquidity can also put you in a better position with financial institutions when
your business needs to request external funding. Much like personal finances, a lender will want to
verify your ability to repay your obligations.
In other cases, you may be asked to produce a financial statement that is intended to provide insights
into your company's financial status. Under these circumstances, the goal is generally the same: There is
a requirement to demonstrate your ability to handle your assets and liabilities properly.
Therefore, managing your liquidity is essential for demonstrating the financial stability of your business,
and it's just good practice to help prevent your business from ending up with financial issues that may
become too difficult to resolve.
Will Investors Look at my Liquidity Ratios When Evaluating my Company?
There are several factors that investors will look at when it comes to evaluating your company, and yes,
liquidity ratios will be something they review. The four factors they will review include your company's
operating cash flow, your balance sheet liquidity, earnings growth on the income statement, and your
return on assets.
In particular, liquidity will be reviewed on the balance sheet in the form of cash, as investors look to see
whether your company has enough money to cover current expenses. Investors will also be looking to
see whether your company could deplete your cash by paying short-term obligations within the same
calendar year. There are also some liquidity ratios on the balance sheet that investors will review that
will indicate how well your company is managing its cash.
Investors will look at your company's financial statements to understand the inherent risks of doing
business with your company. Lenders are looking at them for the same reason, as they need to make
sure they can rely on your payments. For these reasons, establishing a liquidity management strategy
early on could be a big key to your future success.
How is Liquidity in Investing Different?
Liquidity in investing is only slightly different in that it refers to how quickly or easily an investment can
be bought or sold in a secondary market. The easier the purchase or sale, the more liquid the asset is
considered. The most liquid is cash and the least liquid is generally considered to be land, real estate, or
buildings, because it's not easy to predict the length of time it would take to sell any of these and
convert the asset back to cash.
Many terms get used interchangeably in the financial world; however, it is important to understand this
concept when starting, managing, or growing your own business. Being able to demonstrate your ability
to repay loans, to be able to repay a supplier that extends credit to your business, or even just to make
sure you have enough incoming revenue to manage your expenses – each is a key reason to understand
and create a sound liquidity management strategy.