By Karumba Kinyua
As an organisation do you find y o u r s e l v e s running short of cash or having too much (if that is probable)? The ability of a business to one; meet cash or debt obligations or two; trade an asset such as a stock, without incurring substantial losses is what corporates call Liquidity Management. Successful organisations and businesses are required to meet all their financial obligations as they fall and plan for future obligations. To achieve balance of cash flows, i.e. having a positive balance from the difference in amount of cash at the beginning of a period and amount of cash at the end of a period, it is necessary to have in place a Liquidity Risk Management System and practice that will efficiently meet a
company’s present and future financial needs. Finance managers, accountants and treasury department heads require adequate training and skills in managing a company’s ability to meet short term financial demands, which is referred to by experts as Liquidity Risk Exposure.
Investments that businesses make will determine how high or low their
liquidity risk exposure is. The Liquidity Chart to the right shows liquidity of
investments though mainly as made by businesses west of the world. Closer home investments made are mainly in the form of cash, debtors, fixed deposits and real estate. From the chart, cash in hand is the most liquid form of investment, however, there are bank savings and liquid mutual funds that are just as liquid. Investments in real estate and other forms of fixed assets will need specific buyers and time to liquidate. In
light of this, it is now simpler to identify from the chart which form of investment to make. However, it is also important to ensure the organization is not too liquid or not liquid enough also known as over and under liquidity respectively.
What is Over Liquidity and Under Liquidity?
Over liquidity is when a company situates itself in a position where it holds too much cash that should be used in more profitable ways of investment. Equally under Liquidity is when a company holds too little cash that hinders the business from the capacity to pay its due debts and bills. A company can measure its ability to meet short term obligations by keeping track of the ratio of its assets to its liabilities. This ratio is known as the
Current Ratio which is a Liquidity ratio that is informative when it comes to cash flows management. While liquidity needs differ per industry, a cash ratio of 0.5 to 1 is usually preferred.
Current Ratio = Current Assets
Why Practice Cash Flows Management
Cash Flows and liquidity management seek to free up an organization’s finances while at the same time minimizing processing costs of the liquidity. Any cash surpluses are put into profitable use and reduce funding costs in the event of deficits. To ensure effectiveness it is important to practice cash and liquidity management as a daily continuous operation to mitigate any liquidity risks that may arise.
Sources of liquidity risks for a business can be categorised as internal or external. Internal risks being; Concentrating cash balances-is important as a primary account with a high balance will accrue better interest and will in eventuality reduce excess balances; Releasing working capital will require an optimal cash conversion cycle. (File C. a., n.d.)
Financing and liquidity management involves different structures such as
loans, bonds, stock, assets, and trade to raise funds to meet the due obligation from these external risks arise. Factoring, for example, is the exchange of accounts receivable by the business owner in order
to get instant cash from a third party. This is a short term source of financing. Equity financing is the sale of shares to raise capital and is more practical for a large organization that deals with large stock volumes since they are easier to sell.
Asset financing involves the use of business assets such as buildings,
machinery, land, and vehicles. It involves equipment leasing, hire purchase,
finance leases, operating leases, and asset refinance. Project financing relies on the projects cash flow for repayment, with the projects assets, rights, and interests held as secondary collateral. Trade financing enables exporters of goods to get paid by banks through proof of shipment of goods. All these forms of financing have risks involved that may lead to loss or gain. It is paramount that finance personnel understand which works best for their individual organization, be it a private or public institution, so as to reduce liquidity risk exposure.
Banking practices could also present a liquidity risk in the event that a business uses foreign banking and foreign currency accounts for their financial transactions. Monitoring of the costs and charges that occur during a financial transaction will enable businesses avoid losses. Some of
the local banks that offer foreign currency accounts include; Co-operative bank, Equity Bank, Barclays bank. In liquidity management, it is important to keep track of conversion and accounts charges that may affect the liquidity of a business in terms of cash flow, forex charges and risks.
The table below shows the benefits and downsides of using either a foreign currency account or a local account.
Liquidity risk exposure can be monitored
through various strategies one involving:
- Determining liquidity risks promptly –use of risk analysis of extreme
- presumed situations and maintenance of liquid assets.
- Monitor and govern liquidity routinely – once liquidity risks have been identified it is important to monitor and control any risk exposures or funding needs depending on the size of the organization. It should also account for legal entities, business lines and international currencies.
- Conduct planned stress tests – it is wise to conduct consistent financial stress tests for both short term and long term situations to predict different potential liquidity shortfalls.
- Create an Eventuality plan – this involves the use of results obtained from stress tests which enable the organization to fine-tune their liquidity risk management strategies consequently. (Deely, n.d.)
Such a structured plan will provide backing for other measurements like Receivables Management and Netting Portfolio Management Techniques.
The need to adequately manage liquidity has become apparent given the current financial markets and changing policies. Finance professionals interested in minimizing operational risk and resource allocation, improving efficiency while cutting costs, and optimal operation efficiencies will equip themselves with the necessary liquidity management
skills and strategies.
Deely, M. (n.d.). 4 Principles for More
Robust Liquidity Risk Management
Retrieved from BIG SKy: https://www.
File, C. a. (n.d.). Cash and Liquidity Management. Retrieved from CTMFile :
File, C. a. (n.d.). Liquidity Risk
Maangement. Retrieved from CTMFile:
Cash Flows and liquidity management seek to free up an organisation’s finances while at the same time minimizing processing costs of the liquidity.
Any cash surpluses are put into profitable use and reduce funding costs in the event of deficits. To ensure effectiveness it is important to practice cash and liquidity management as a daily continuous operation to mitigate any liquidity risks that may arise.