The ultimate guide to liquidity and cash flow

Establishing a resilient cash flow and liquidity reserve is crucial for navigating volatile business environments. Here is everything you should know about liquidity and cash flow.


Establishing a resilient cash flow and liquidity reserve is crucial for navigating volatile business environments. Here is everything you should know about liquidity and cash flow.

Companies frequently encounter fluctuations in their funds, influenced by internal factors like investments, as well as external factors such as economic cycles or delayed customer payments.

Building and maintaining a robust liquidity reserve is paramount for not just surviving but thriving in such ever-changing environments.

In this article, we will explain the concept of liquidity and explore proactive measures you can take to enhance your access to cash and manage your cash flows.

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What is liquidity?

Liquidity is a crucial concept in finance, denoting a company’s capacity to swiftly convert its assets into cash or readily access cash.

Having a robust liquidity reserve is crucial for business growth and survival. Without liquidity, you are not able to make investments, which, in turn, is likely to affect performance.

What is cash flow?

Cash flow refers to the movement of money in and out of a business.

Unlike liquidity, the ability of a company to settle its debts cannot be accurately assessed solely by examining its cash flow. Instead, cash flow is a measure of how much cash is brought in or out of a business in a period of time.

Calculating liquidity ratios

One of the most common ways of measuring liquidity is with liquidity ratios.

Liquidity ratios are considered a better measure of liquidity than cash on hand because they provide a more comprehensive assessment of a company’s ability to meet its short-term obligations.

The current ratio and quick ratio are both liquidity ratios that measure a company’s ability to pay off its short-term liabilities with its short-term assets. However, they have some differences in their calculations and interpretations.

The current ratio includes all current assets, while the quick ratio only includes quick or liquid assets excluding inventory from the calculation, making it more conservative.

Both ratios are helpful for financial analysis, but the choice between them depends on your specific concerns and the industry of the company being analysed.

Liquidity Ratio 1 (Current Ratio):

Formula: Current Assets / Current Liabilities

Example: If your current assets are €100,000 and current liabilities are €80,000,

Calculation: €100,000 / €80,000 = 1.25 or 125%

A current ratio over 100% indicates having more current assets than needed to cover expenses. However, considering uncertainties in receiving payments, aiming for a ratio of 2 (200%) or higher is advisable for robust liquidity.

Liquidity Ratio 2 (Quick Ratio):

Formula: (Current Assets – Inventory) / Current Liabilities

Example: Using the previous data with inventory at €40,000,

Calculation: (€100,000 – €40,000) / €80,000 = 0.75 or 75%

The quick ratio, excluding less liquid assets like inventory, should ideally be above 100% for better liquidity.

Cash flow forecasting for liquidity management

Cash flow forecasting is the process of estimating cash inflows and outflows to predict what the liquidity reserves will look like over a period of time.

By estimating the future cash balance, businesses gets a clearer picture of how their financial situation will evolve.

How to forecast cash flows

To create a simple cash flow budget, you can follow these steps:

1. Define your forecasting period:

Begin by determining the timeframe for your forecast. A shorter time period increases the accuracy of your predictions. For instance, if you opt for a three-month focus, create a spreadsheet with three columns, each representing a month.

2. Set up the spreadsheet:

In the first column, start by entering the initial cash balance for the period. Below it, list anticipated cash inflows and outflows. By combining the initial balance with the net change in cash flow during the month, you can calculate the estimated cash balance at the end of each month.

3. Repeat for subsequent months

Apply the same process to the following months, adjusting the values based on your expectations for each period.

Business Victoria has a free cash flow forecasting template. Download Business Victoria’s free cash flow forecast template.

Improving liquidity

Enhancing liquidity is a continuous effort, and effective cash flow forecasting lays the groundwork for this improvement.

Here are our best tips to improve your company’s cash flow situation:

  • Improve your invoicing procedures: Send invoices promptly after completing a job to get paid faster. You might also consider to recude the credit time you offer customers if that is a possibility.
  • Proactive payment reminders: In instances where customers fall behind on payments, promptly dispatch payment reminders.
  • Apply for a credit line: Explore the possibility of securing a credit line, allowing you to pay interest solely on the borrowed amount and duration. This financial tool provides flexibility in managing short-term cash needs.
  • Manage supplier relationships: Negotiate extended payment terms with suppliers and explore opportunities to increase credit limits, particularly with key suppliers. Cultivating strong supplier relationships can contribute significantly to managing cash flow effectively.
  • Optimise inventory management: Trim excess inventory to prevent the unnecessary tying up of capital. Implementing efficient inventory management practices ensures that resources are allocated judiciously, further supporting liquidity goals.

BONUS TIP! Cut costs. You could, for instance, switch to a free invoicing software such as Conta. Get your free invoicing software.