Liquidity management: What it is and how it works

As you dive into the world of managing cash flow, revenue, and business expenses, you’ll likely come across this term “liquidity management.”

What is liquidity management? Is it something all businesses need to think about? And what are the pros and cons?

In this article, we’ll answer all of those questions. We’ll explain what liquidity management is and why it's important, the different types of liquidity, and best practices for managing liquidity in your own organization.

What is liquidity management?

Liquidity management is the monitoring, forecasting, and optimization of cash flow to ensure that a business can meet its shorter-term obligations and operate efficiently.

It involves monitoring, forecasting, and optimizing cash flow to ensure a business can meet short-term obligations and operate efficiently.

Importance of liquidity management in business 

Good liquidity management practices are important as they help to:

• Ensure solvency, helping to avoid cash shortfalls and prevent financial distress.
• Support growth, enabling timely investments and allowing your business to seize growth opportunities.
• Improve efficiency, allowing you to optimize working capital and reduce funding costs.
• Enhance resilience, preparing businesses for economic or operational disruptions.

Types of liquidity 

Liquidity is a term that’s used in a variety of contexts.

Here are the five most common types of liquidity:

1. Asset liquidity: The ease of converting a given asset into cash without significantly impacting its current value.
2. Market liquidity: The ability to buy or sell assets in a given market without causing drastic price changes.
3. Accounting liquidity: A company’s ability to meet its short-term liabilities using its current assets.
4. Cash liquidity: The amount of cash or cash equivalents a business has readily available.
5. Funding liquidity: A company’s ability to raise funds to meet obligations through borrowing or asset sales.

Best practices for managing liquidity

1. Keep on top of cash flow 

The best way to start improving liquidity is to monitor cash flow.

You should:

• Track inflows and outflows, creating a detailed cash flow statement on a regular basis (weekly or monthly)
• Develop cash flow projections to identify potential liquidity shortfalls or surpluses
• Leverage cash flow management tools to automate monitoring and improve accuracy

Tools and techniques for optimizing cash flow

Here are a few quick tips and techniques for optimizing the flow of cash in and out of your business:

• Implement automated invoicing and payment reminders to reduce delays in receiving payments from customers 
• Negotiate longer payment terms with suppliers and shorter terms with customers to optimize your ability to manage cash on hand
• Use expense management tools to monitor and control operational spending
• Adopt inventory management systems to reduce overstocking and free up cash
• Maintain pre-approved lines of credit or overdraft facilities for quick access to funds when you need them
• Focus on improving the Cash Conversion Cycle (CCC) to reduce the time it takes you to convert your investments in inventory into cash from sales 
• Implement a subscription-based model or use retainer agreements where possible to improve the reliability and predictability of cash inflows
• Use factoring or accounts receivable financing to access cash from outstanding invoices 

2. Keep a good liquidity buffer 

By keeping a portion of your business funds in highly liquid assets (like cash or short-term investments), you’ll improve your ability to handle unexpected expenses or revenue dips.

3. Diversify your funding sources 

Try to reduce dependency on a single lender. Instead, establish multiple funding sources, such as banks, private equity, venture capital, or pre-approved lines of credit.

This will improve your funding liquidity and give you more sources to draw on for quick access to capital.

4. Conduct liquidity stress tests 

One of the most important parts of managing liquidity is to understand how prepared your business is for worst-case scenarios by conducting stress tests.

You’ll simulate adverse events like revenue declines, market downturns, or large unexpected expenses like post-disaster cleanups, to understand the impact of such events on liquidity.

Then, you’ll develop clear action plans to address such liquidity pressures during stress scenarios, such as establishing an emergency line of credit that is available to you in the event of a natural disaster.

How to assess liquidity

A critical first step in conducting a liquidity stress test is being able to measure and assess liquidity, both now and within a given context.

Here are a few quick liquidity ratios you can use:

• Current ratio: Current assets / Current liabilities. This ratio measures your ability to cover short-term liabilities with current assets.
• Quick ratio (acid test): (Current assets - Inventory - Prepaid expenses) / Current liabilities. This ratio measures your ability to cover short-term liabilities with your most liquid assets.
• Cash ratio: Cash and cash equivalents / Current liabilities. This ratio measures your ability to cover short-term liabilities with the cash you have on hand right now.

5. Align asset maturities with liability timelines 

A good strategy for ensuring you’re always liquid enough to meet your liabilities is to match asset maturities with the due dates of your liabilities.

For example, you’ll want to structure your asset investments such that they become liquid just before longer-term liabilities such as debt repayments become due, freeing up that investment as a more liquid asset that you can then use to meet your financial obligations.

6. Monitor economic, industry, and other risk factors 

Many of the biggest risks to liquidity are those that you can’t actually control, such as interest rates, inflation, and other macroeconomic factors that impact liquidity.

As such, it's a smart idea to stay informed of economic and industry changes and be prepared to respond to these by revising cash flow forecasts or adjusting spending accordingly.

Understanding the factors that can impact liquidity risk is an important first step here.

Factors that impact liquidity risk

• Operating cash flow volatility: Inconsistent cash inflows.
• Credit risk: Late payments or customer defaults.
• Market conditions: Economic downturns, inflation, or rising interest rates.
• Asset liquidity: Holding too many illiquid assets.
• Leverage levels: High debt obligations.
• Funding concentration: Reliance on a single funding source.
• Working capital management: Inefficient receivables, payables, or inventory management.
• Regulatory changes: New compliance costs or restrictions on funding.
• External shocks: Pandemics, geopolitical tensions, or natural disasters.
• Industry-specific risks: Seasonal demand or competitive pressures.

7. Establish clear liquidity policies 

Developing, documenting, and distributing clear and easy-to-follow liquidity policies is one of the best ways to protect your business against liquidity risks.

Set minimum cash reserves, define roles for managing liquidity, and establish a cadence for reviewing and updating liquidity guidelines to reflect changes in business operations or market conditions.

8. Leverage technology 

If getting on top of cash flow and liquidity is your goal, financial tech is your best friend.

You can use specialized treasury management systems (TMS) to consolidate data and monitor liquidity in real time, and invest in financial forecasting tools to access predictive analytics and scenario modeling, opening up more effective liquidity contingency planning.

Role of technology in liquidity management

Using modern technology to support liquidity management can provide:

• Real-time cash visibility with a centralized view of cash positions across accounts and geographies
• Predictive analytics tools that can analyze historical data and market trends to enhance cash flow forecasting accuracy
• Automated alerts and stress testing to help identify potential liquidity risks early and provide strategies for mitigating them

Automation and integration for efficient liquidity management

All of the powerful tools in the world aren’t helpful if they’re just slowing you down. That’s why it's important to consider the automation features and integration capabilities of the software solutions you’re thinking about bringing on board.

Here are a few important considerations and features to look out for:

• Automated payments and collections to reduce errors and streamline invoicing and payment processing
• Integrated banking, accounting, and ERP systems to streamline liquidity management
• AI and machine learning to automate cash flow analysis, detect anomalies, and help optimize funding allocations 

9. Manage operational efficiency 

Our final tip is to stay on top of operational efficiency by optimizing your cost structures.

You’ve got two kinds of costs to think about—fixed costs and variable costs—and these need to be addressed differently:

1. Fixed costs. Look for opportunities to reduce overall overhead.
2. Variable costs. Be prepared to adjust operational spending in response to revenue fluctuations.

Improve liquidity management with BILL 

Committed to improving your ability to manage liquidity?

BILL’s integrated financial operations platform is stacked with powerful features to support liquidity management, from expense tracking to cash flow forecasting.