Everything you need to know about liquidity

What does liquidity mean?

Liquidity is the ability of a company to meet its payment obligations within a certain period of time. If a company is liquid, it has

sufficient funds to meet its payment obligations for salaries, rent, utilities, and other services. It can draw on bank balances and cash on hand. As soon as a company is no longer able to meet these obligations in the long term and cannot change this in the short term, it becomes

insolvent and faces the threat of bankruptcy.

Liquidity vs. Cash Flow

When dealing with the topic of liquidity, you will often come across the term cash flow. These terms are often mistakenly used synonymously, even though they describe two very different things. While liquidity provides information about the availability of liquid funds at a specific point in time, cash flow measures changes over a period of time by comparing cash inflows and outflows. In this article, we focus on the topic of liquidity.

Why is it important to address liquidity?

Only when a company is liquid will it receive loans from banks or deliveries on

account from suppliers and service providers. To obtain information about the liquidity of customers and thus minimize the risk of payment defaults, banks and suppliers regularly carry out credit checks. For the successful management of a

company, it is therefore essential to address your liquidity.

How is liquidity measured?

A company's liquidity is measured internally using so-called liquidity ratios, which refer to specific reporting dates and are therefore static:

Cash ratio (liquidity of the first degree)

The cash ratio, also known as liquidity of the first degree, is calculated as follows:

(Cash and cash equivalents) / (current liabilities) x 100 [%]

The recommended value is between 10% and 30%. Cash and cash equivalents include balances in business accounts as well as cash on hand, checks, and discountable bills of exchange. They can be used immediately to pay invoices. Current liabilities are loans and supplier credits with a remaining term of less than one year, as well as provisions for items such as tax payments, bonus payments, new acquisitions, and repairs.

Quick ratio (liquidity of the second degree)

The quick ratio is also known as liquidity of the second degree. It calculates

as follows:

Short-term receivables include receivables with a payment term of less than one year. The recommended value here is between 100% and 120%. A value of less than 100% means that short-term liabilities cannot be covered by liquid assets available in the short term.

Current Ratio

The current ratio, also known as working capital ratio or liquidity of the third degree, is calculated as follows:

(Cash and cash equivalents + short-term receivables + current assets securities + inventories) /

(short-term liabilities) x 100 [%]

A company's inventories reported on the balance sheet are included in the calculation of the

current ratio. This includes raw materials, consumables and supplies, work in

progress, finished goods in stock, and advance payments made for required

materials. The recommended value is between 120% and 200%. A value below 120% indicates that the total liquidity tied up in current assets is insufficient to cover short-term liabilities. A value above 200% could mean that too much liquidity is tied up in inventory, which in turn is not available to cover payment obligations.

Optimal liquidity

Unlike the terms cash flow and liquidity, the terms cash flow management

management and liquidity management can be used synonymously, which is what we will do in the following.

The goal of cash flow management is, simply put, to ensure the liquidity

of a company. To achieve this, cash inflows and outflows must be optimally planned,

managed, and monitored so that the company remains solvent at all times and

surplus liquidity is invested wisely.

If liquidity is too low, the company must take measures to increase it.

One option is to shorten payment terms for customers in order to achieve

faster payment receipts. In addition, capital can be freed up by reducing

be released from inventory. Larger companies can increase their liquidity by, for example, selling company shares.

Since an excess of liquidity is also undesirable, the entrepreneur must also

take countermeasures here. When investing available capital, however, one must always ensure

not to invest more than is necessary to promote the company's growth

while simultaneously ensuring solvency.

Why is cash flow management so important?

Structured and diligent cash flow management is the foundation for long-term

successful business management. This management helps to identify potential liquidity bottlenecks as well as unused investment opportunities resulting from cash surpluses early on. Furthermore, it enables the entrepreneur to control cash flows, optimally manage receivables, and plan financing and investments.

Who is liquidity management important for?

Cash flow management does not only become relevant after many years or once a certain

company size is reached; it should be part of every entrepreneur's business practice from the very beginning. Cash flow management not only helps companies remain profitable in the long term, but also provides key insights for highly individual, future-oriented business decisions. For example, a tradesperson can learn how much money they can safely withdraw from the business, a founder can plan new hires sustainably, and a medium-sized business owner can learn more about their liquidity structure.

Liquidity planning

Although cash flow management is highly recommended for every entrepreneur, many

start late or not at all. This is partly due to chronic lack of time, but

also to the lack of knowledge among many entrepreneurs regarding where and how to start. However, the first step toward liquidity management should always be the creation of a liquidity plan.

Why do you need a liquidity plan?

The goal of liquidity planning is to make assumptions about the total cash flows in the

business account for a specific period. This means that

hypotheses about future business development are also made. It is useful here to

run through various so-called scenarios: What happens if a customer in

falling behind on payments? And what are the effects of a decline in sales, as many

business owners are currently experiencing due to the coronavirus crisis?

The goal is to identify available liquid assets for specific points in the future, thereby providing the business owner with planning security. Knowing how much liquidity will be available in two weeks, three months, or a year is a significant competitive advantage for any company.

Structuring liquidity planning

First, the business owner must be aware of their cash position. This includes

balances in business accounts, cash on hand, checks, and discountable

bills of exchange. Since this balance is not set in stone but changes constantly, liquidity planning must be continuously adjusted. Furthermore, the items for the liquidity plan must be established. This includes all incoming and outgoing payments.

Incoming payments include:

• Payments from sales and the provision of services
• VAT receipts
• Other operating income, such as tax refunds or loan proceeds

Outgoing payments include:

• Purchases of goods
• Personnel costs
• Fixed-term contracts
• Other operating expenses, such as travel costs, advertising costs, and rent

The simplified, schematic structure of liquidity planning is as follows:

Liquidity balance

+ Incoming payments within a period

= available funds

- Outgoing payments within a period

= cumulative liquidity

What are the challenges in liquidity planning?

The difficulty with liquidity planning lies in creating realistic scenarios and

recording cash flows accordingly. This is the foundation for business owners to

plan as accurately as possible and derive key business decisions.

This becomes particularly difficult when unforeseen and uncontrollable external factors arise.

A prime example of this is, of course, the COVID-19 crisis, which occupied many entrepreneurs

on a daily basis. Even though many support measures for entrepreneurs have already been decided and initial

financial aid has been paid out, the crisis has still had a major impact on corporate liquidity. When planned revenue is delayed or fails to materialize entirely, while expenses cannot be reduced to the same extent, this can quickly lead to serious liquidity bottlenecks that must be addressed with proactive measures.

Tidely helps you keep your business finances under control at all times through intelligent liquidity planning. Thanks to smart cash flow forecasting, you can predict your liquidity levels for any point in time and test the financial impact of your business decisions using scenario analysis. Optimize your liquidity management without complex setups, error-prone Excel spreadsheets, or outdated data. See for yourself.

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