Importance of liquidity management

What is meant by liquidity and cash management in business?

As people say, cash is king and good control of your financial resources is a must if you want your business to be successful.

If you are a budding businessman or businesswoman, then it all starts with a business idea and possibly a few friends who share your enthusiasm for the idea. You may decide to start an experiment at first and avoid making heavy commitments about a new product or service. It will only be a test. However, if your Proof of Concept (PoC) works well and you feel your idea has a competitive advantage, you may then think to start the real business.

It doesn’t matter if your company will be a sole proprietorship, partnership or limited liability company. You have to think seriously about how you are going to finance your newborn business. It is impossible to run a business without cash. You may be smart enough to start with almost zero capital, but you will soon find out that you have a growing amount of cash at your disposal. This cash will be needed to pay for purchased goods, transportation, marketing, taxes and much more.

Yes, you will receive cash from your customers if you have a right product on offer, but the money will usually arrive at a different time than the bills are due. This mismatch of incoming and outgoing cash requires your attention. In addition, you may quickly realize that you need more cash as your business is growing rapidly. The extra cash may come from a variety of sources, but in any case, you are committed to paying it back at some point. The more cash you have, the more time you will have to spend managing it.

You will need to make sure your cash is available to cover operating expenses, bank installments, leasing, and so on. Your cash will need to be available at the right time and in the right amount, which ultimately becomes your liquidity management process. You need to make sure that you pay on time, without delays, arrears, because this may lead your company to bankruptcy or at least lose credibility in the eyes of contractors. If you lose credibility, you will have trouble doing business with people. Trust is very important in business and you have a chance to build it by fulfilling your financial obligations.

So how do you start managing your liquidity?

It might be as simple as running private affairs at first, but if your business becomes more complex, you'll need to set up a process. You should start from top to bottom by looking at the business plan first. What are your goals, how do you want to achieve them and by when? If you've written a business plan before, you've probably already thought of a lot of things. Now it's important to look at your business from a helicopter view. It's not about micromanaging your daily activities but to see the big picture.

The business plan should include calculations that will transform your plan into meaningful numbers. This will be done in the form of a financial model and if you don't have the skills to do so, ask for outside help. The financial model will provide you with a lot of important information, for example about how much you can earn over the years and how much it will cost you to run your business. The financial model should have a part related to cash, and this part is called the cash flow projection. This is a very important section of your model as it will tell you how much cash you will need at any given time and how much cash you can generate from your operations.

The cash flow forecast predicts an unknown future and is a difficult task, but managing a business is always about predicting the future. As soon as you kick off, you'll find that your plans need updating from time to time. By updating, you will be able to measure how much you are deviating from the original assumptions and whether you are still on the right track to make this business viable and profitable.

A cash flow projection shows the cash inflows and outflows over the forecast period. It can show forecasts for the next few years for 3, 5 or even more years, depending on your specific business requirements. The calculations will show how much cash is needed each year and how much cash the business will generate. Thanks to this knowledge, you will be able to prepare yourself for finding sources of capital. It is very important to know your capital needs in advance and plan financing accordingly. Your plan should include amounts of money to be received from each source and when you will need it. You should also consider what you will do if you cannot get financing from your preferred source. It's always a good idea to have an alternative plan before real problems arise.

Once you have a plan for each year, you should start working on a detailed plan for the next 12 to 24 months, which will be your budget. Now is the time to move from an overall business plan to a detailed monthly budget. You'll need some experience to make this an effective budget, so outside help from a professional advisor would be a good idea. Each company can have its own specifics, and the budget should present such things. For example, sales can be very seasonal, while costs can be incurred much earlier. You may need a large amount of cash for several months before receiving any proceeds in your bank account. The business plan may not show these types of cash commitments, but your monthly budget will do.

After you prepare the budget, you will need to review your initial liquidity plan. If you find out well in advance what your actual cash needs are during the year, you will have time to prepare. You can also run different scenarios to determine how you will manage your liquidity if circumstances start to change. Think about what threats you may face during the year and what you will do about it.

The budget is already a fairly detailed plan, but it may not be enough to avoid liquidity problems. Depending on the size and complexity of your business, you will have to move on to operational planning of your cash, which is called cash management and is a part of treasury function. It is the process of short-term cash flow forecasting, often for a period of 30, 60 or even 90 consecutive days. It is advisable to use a dedicated tool that will integrate your accounting and banking systems into one platform as you will need accurate information for each working day.

The purpose of this planning is to make sure you have the money to meet your obligations such as payroll, taxes, social security, utility bills, bank installments, leasing fees, and so on. Think about the consequences if you miss important payments by even a day. Keeping track of all your commitments can be really grim and time consuming, so it's wise to plan ahead and do it effectively. The plan should include terms of payments granted to customers, as well as negotiated with suppliers, conditions under which loans are granted, credit cards, bank account debt, bank guarantees, factoring, all short-term financial facilities, etc.

As your business grows, the complexity of cash management issues will also become more complex. In fact, these operations are most likely not the backbone of your business, and while you should be careful about what happens to your cash, you should pay more attention to the things that make your business grow. Liquidity management is not a core business for most firms and therefore they should outsource these functions to the extent that makes sense and is safe for the business. However, it cannot be left without proper planning and control by the business owner.