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 specified period of time. If a company is liquid, it has sufficient funds to cover its payment obligations for salaries, rents, utilities, and other services by drawing on bank deposits and cash balances. If a company cannot meet these obligations in the long term and cannot change this situation quickly, it becomes insolvent.

Liquidity vs. Cash Flow

When dealing with liquidity, one often comes across the term cash flow. These terms are often used synonymously, although they describe very different things. While liquidity reflects the availability of liquid assets at a specific point in time, cash flow measures changes over time through the comparison of cash inflows and outflows. This article focuses on liquidity.

Why is it important to address liquidity?

A company must be liquid to receive loans from banks or deliveries from suppliers. To minimize the risk of payment defaults, banks and suppliers regularly conduct credit checks to get information about a customer's liquidity. Therefore, it is crucial for the successful management of a company to address its liquidity.

How is liquidity measured?

Liquidity of a company is measured internally using specific liquidity ratios that relate to particular dates, and thus are static:

First Degree Liquidity

First Degree Liquidity, also known as the Cash Ratio or Bar Liquidity, is calculated as follows:

Cash Ratio=(Liquid Assets/Short-term Liabilities)×100%

The recommended value ranges between 10% and 30%. Liquid assets include balances from business accounts, cash on hand, checks, and immediately cashable securities. Short-term liabilities include loans and payable bills. These assets can be used to pay bills immediately, covering less than one year, including provisions for things like taxes, bonuses, new acquisitions, and repairs.

Second Degree Liquidity

Second Degree Liquidity, also known as the Quick Ratio or Acid Test Ratio, is calculated as follows:

Quick Ratio=(Liquid Assets + Receivables due within one year/Short-term Liabilities)×100%

A value of at least 100% indicates that short-term liabilities can be met with liquid assets and receivables due within a year.

Third Degree Liquidity

Third Degree Liquidity, also known as the Current Ratio or Working Capital Ratio, is calculated as follows:

Current Ratio=(Liquid Assets + Receivables + Marketable Securities + Inventories) / (Short-term Liabilities)×100%

Inventories, including raw materials, work-in-progress, and finished goods, along with prepayments made for necessary materials, are incorporated into this calculation. A recommended value is between 120% and 200%. A value under 120% suggests that too much capital is tied up in inventories not covering payment obligations, while a value over 200% might indicate excessive liquidity that is not being utilized effectively.

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Optimal Liquidity

Contrary to the terms cash flow and liquidity, the terms Cash flow Management
and liquidity management can be used synonymously, as we will do henceforth.

The goal of Cashflow Management is, simply put, to ensure the liquidity of a company.
To achieve this, cash inflows and outflows must be optimally planned and controlled so
that the company is always able to make payments and invest excess liquidity sensibly.

When liquidity is too low, the company must take measures to increase it.
One way to do this is to shorten payment targets for customers to achieve
faster receipt of payments. In addition, capital can be released by reducing inventory levels.
Larger companies can also increase their liquidity, for example, by selling parts of the business.

Since an excess of liquidity is also undesirable, the entrepreneur must also counteract this.
When investing the available capital, care must always be taken not to invest more than is necessary
to promote the growth of the company and at the same time ensure its ability to make payments.

Why is Cashflow Management so important?

Structured and careful Cashflow Management is the foundation for long-term successful business management. This management helps to identify potential liquidity bottlenecks and unused investment opportunities through early detection of liquidity surpluses. It also enables the entrepreneur to optimally manage cash flows, handle receivables, and plan financings and investments.

Who is Liquidity Management Important For?

Cashflow Management should not only become relevant over the years or from a certain company size but should be part of the business practices of every company from the start. Cashflow Management not only helps a company to be profitable in the long term but also provides important insights for highly individual, future-oriented business decisions. Thus, a craftsman learns how much money he can conscientiously take out of the business, the founder can plan new hires sustainably, and the medium-sized business owner learns more about his liquidity structure.

Liquidity Planning

Although Cashflow Management is absolutely advisable for every entrepreneur, many only start with it much later, if at all. This is due to a chronic lack of time, and for others, it is due to the ignorance of many entrepreneurs about where and how to start. However, the first step towards 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 assumptions about

future business development are also made. Here, it makes sense to play through

various so-called scenarios: What happens if a customer delays payment?

And what are the implications of a drop in sales like many entrepreneurs are currently

experiencing due to the COVID-19 crisis?

The aim is to show the available liquid assets for certain points in the future and thereb give the entrepreneur planning security. Knowing how much liquidity will be available in two weeks, three months, or a year is an important competitive advantage for the company.

Structure of Liquidity Planning

Firstly, the business owner must be aware of the cash balances. This includes the balances on business accounts, cash on hand, cheques, and discountable bills. As this inventory is not set in stone but rather subject to change, liquidity planningmust be continuously adjusted. This includes setting up the liquidity plan, which consists of inflows and outflows.

Inflows include:

• Receipts from sales and provision of services
• VAT payments
• Other operational receipts, such as tax refunds or loan proceeds

Outflows include:

• Purchases of goods
• Personnel costs
• Long-term contracts
• Other operational expenditures, like travel expenses, advertising costs, and rents

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

Liquidity balance
+ Inflows within a period
= Available funds
- Outflows within a period
= Cumulative liquidity

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What are the Challenges in Liquidity Planning?

The challenge in liquidity planning lies in setting up realistic scenarios and planning the cash flows as accurately as possible. This is the foundation for entrepreneurs to make the most accurate business decisions possible. This becomes particularly challenging when unforeseen and uncontrollable external factors occur.

A prime example of this is naturally the Corona Crisis, which has occupied many entrepreneurs daily. Even though many financial aid measures for businesses were quickly decided and distributed, the crisis has significantly impacted the liquidity of businesses. When planned revenues are delayed or even fail completely, it can quickly lead to serious liquidity shortages, which require immediate countermeasures.

Tidely helps you manage your finances by keeping intelligent liquidity planning under control at all times. Thanks to smart Cashflow Forecasting, you can predict your liquidity status for any given moment in the future and analyse the financial impacts of your business decisions based on scenario analysis. Optimise your liquidity management without the need for cumbersome set-up or error-prone Excel spreadsheets. Convince yourself.

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