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.

Companies frequently encounter fluctuations in their funds, influenced by internal factors like investment, 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 this ever-changing landscape.

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.

See also: Free cash flow forecast template

What is liquidity?

Liquidity, a crucial concept in finance, means 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 company 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 over 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.

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 are some differences in how they are calculated and interpreted.

The current ratio includes all current assets, while the quick ratio only includes quick or liquid assets and excludes inventory from the calculation. This makes quick ratio more conservative.

Both ratios are helpful for financial analysis, but which will be better for your company depends on what you want to look at, and which industry you are operating in.

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 above 100% indicates that you have more current assets than you need to cover expenses. However, considering uncertainties in receiving payments, aiming for a ratio of 2 (200%) or higher is advisable to ensure robust liquidity.

Liquidity ratio 2 (quick ratio):

Formula: (Current assets – Inventory) / Current liabilities

Example: Using the previous data and adding an inventory of $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% to ensure good 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 time frame of your forecast. A shorter time period increases the accuracy of your predictions. For instance, if you opt for a three-month time frame, create a spreadsheet with three columns, each representing a month.

2. Set up a spreadsheet:

Start by entering the initial cash balance for the period in the first column. Below, 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.

Don’t want to do it on your own? You can download our free cash flow forecast template.

Improving liquidity and cash flow

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

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

• Improve your invoicing procedures: Send invoices promptly after completing a job to get paid faster. You might also consider reducing the payment deadline for your customers.
• Proactive payment reminders: In instances where customers fall behind on payments, promptly send 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.
• Optimize 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 your liquidity goals.

BONUS TIP! Cut costs. You could, for instance, switch to a free invoicing software such as Conta. You can sign up and start sending invoices for free today.