Everything you need to know about liquidity

What does liquidity mean?

Liquidity is a company's ability to meet its financial obligations within a given timeframe. When a business 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 bankruptcy.

Liquidity vs. Cash Flow

Anyone exploring the topic of liquidity inevitably comes across the term cash flow. These terms are often mistakenly used interchangeably, even though they describe two very different things. While liquidity reflects the availability of funds at a specific point in time, cash flow measures changes over a period by comparing cash inflows and outflows. In this article, we focus specifically on liquidity.

Why is it important to address liquidity?

Only if a company is liquid will it secure bank loans or trade credit

from suppliers and service providers. To evaluate customer liquidity and minimise the risk of default, banks and suppliers regularly conduct credit checks. Successfully running a

company, it is therefore essential to address your liquidity.

How is liquidity measured?

A company's liquidity is measured internally using 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 and liquidity management can be used interchangeably, which is what we will do throughout this article.

Put simply, the goal of cash flow management is to safeguard 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 action to

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 excess liquidity is also undesirable, business owners 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, diligent cash flow management forms the foundation for long-term

business success. It helps leaders identify liquidity bottlenecks and unexploited investment opportunities from surplus cash well in advance. It also allows entrepreneurs to steer cash flows, optimize receivables management, and plan financing and investments effectively.

Who is liquidity management important for?

Cash flow management is not something that only becomes relevant over time or once a business reaches a certain

size; rather, it should be part of every entrepreneur's standard business practice from day one. Cash flow management not only helps companies remain profitable over the long term, but also provides vital insights for tailoring forward-looking business decisions. A tradesperson discovers how much money they can safely draw from the business, a founder can plan new hires sustainably, and an SME gains deeper visibility into its liquidity structure.

Liquidity planning

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

many start late or not at all. On the one hand, this is due to a chronic lack of time; on the

other, it stems from uncertainty among many business owners about where and how to begin. However, the first step in liquidity management should always be creating a liquidity plan.

Why do you need a liquidity plan?

The objective of liquidity planning is to make assumptions about overall cash flows across 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 map out available cash resources for specific points in the future, providing business owners with planning certainty. Knowing how much liquidity will be available in two weeks, three months, or a year gives the company a crucial competitive edge.

Structuring liquidity planning

First, business owners need to know their exact cash balance. To do this,

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

change. Because this balance is not set in stone but is constantly changing, your liquidity planning must also be continually adjusted. In addition, the line items for the liquidity plan need to be determined, which includes cash inflows and outflows.

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 smart liquidity planning. Thanks to intelligent cash flow forecasting, you can project your cash balance for any given point in time and use scenario analysis to test the financial impact of business decisions on your liquidity. Optimize your liquidity management without complex setups, error-prone spreadsheets, or outdated data. See for yourself.

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