In today's business world, cash flow is the most important factor for any company's survival. With a decent cash flow, your business can minimize the risks of liquidity and manage obligations concerning cash and liabilities. What exactly is liquidity?
Simply put, liquidity is a company's ability to meet collateral and cash responsibilities without suffering serious losses. That's why every small business needs to have a liquidity management in place. The main reason is that most startups and small businesses ultimately fail due to cash flow issues. As a matter of fact, 60% of startups that have failed was due to their inability to generate enough cash.
As mentioned before, the amount of cash small businesses have on-hand determines their ability to make investments, reduce costs, and pay their debts.
Therefore, liquidity management can help small organizations assess their assets and liabilities to determine cash inflow and outflow, thus mitigating the risks of failing to meet their obligations. In other words, liquidity management can help small businesses have enough cash on them at all times, so they can effectively fulfill their responsibilities. Here are a few reasons why liquidity management is important for small businesses.
Why liquidity and its management is important
When it comes to running a business, and especially when talking about small businesses, liquidity is the number one necessity. Simply put, if your business is not liquid, you won't be able to make your routine payments, purchase office supplies, cover potential unexpected costs or make a good investment should the opportunity arise. To make it even more understandable, we can compare the liquidity of a business with a common household budget.
When a person gets their salary, they usually cover all their monthly costs, and the amount of money they are left with at the end is their household's "liquidity". So, just like you need to manage your household budget to cover all of your monthly expenses and put enough money on the side for those "rainy days" and day-to-day expenses, you need to have a good liquidity management plan for your business.
The only difference is that a business can have good revenue and profits, but still have financial difficulties if it doesn’t have a good cash flow. Therefore, it can be easily concluded that without a proper liquidity management, a business won't be able to properly manage their assets and cash flow. Furthermore, without a positive cash flow, small businesses have no ways to take advantage of investment opportunities or meet their liability obligations, which ultimately leads to more debt and even bankruptcy.
Profit doesn't mean liquidity
Liquidity is mostly measured by the amount of cash flow a company has. However, just because a business is profitable, it doesn't mean that they have a positive cash flow. In fact, profitable businesses that don't have a good cash flow can easily go bankrupt. Profit, also known as net income, is a company's asset from sales income after deducting all expenses.
Obviously, a company cannot be successful if it isn't profitable, but that doesn't mean it can't fail in the meantime. Let's illustrate this with an example. You manufacture the product that does well on the market. However, the customers who purchased the product have 120 days on their invoice receipt to pay for it. During those 120 days, you have to pay the suppliers, your employees, and the bills.
In this particular situation, your business is profitable, but it has no positive cash flow, meaning you either have to find additional sources of cash to pay for the expenses or declare bankruptcy. With liquidity management strategy, you're able to prepare for these kinds of situations and ensure your business has cash on-hand to meet its liabilities. For instance, invoice factoring you can get you instant cash for a small fee, while factoring companies collect payments from your customers when they're due.
Always have a cash budget
Cash is king in the finance world and it's the most important asset any company needs to have. The main reason is that cash is the most liquid asset and can instantly be turned into other assets. For example, if you have $2,000 in cash, you can instantly pay that amount in bills. On the other hand, if you have four products each worth $500, you'll need time to sell these products and convert them into cash.
That being said, having cash allows you to cover liabilities when needed and seize good investment opportunities when they present themselves. Through liquidity management, you can easily plan out for cash budgets and anticipate the amount of cash your business will need for future endeavors. The budget should be prepared six to twelve months in advance in order to effectively meet your business needs.
However, should those needs change, you can always apply for personal cash loans to ensure that your budget can cover the expenses. Cash loans are easy to obtain and have favorable interest rates.
Reducing the costs
Liquidity management primarily consists of conducting financial ratio analysis on a regular basis. Simply put, business owners must analyze their accounting ratios to determine the financial aspects that include cash that's available for spending or investing, the amount of cash due from customers' purchases, as well as cash tied up in immovable or movable assets.
That way, business owners can identify their company's financial statement based on numbers indicated by your balance sheets, cash flow and income statements. What's more, you're able to analyze your current assets, such as cash flow, accounts receivable, inventory, and long-term assets, in order to effectively determine inflows and outflows of cash. That being said, accounts receivable and inventory are two assets that can drain your cash faster than any other.
However, liquidity management helps you create payment strategy with both your customers and suppliers in order to maintain a positive cash flow. In addition, you can assess your inventory and determine whether products are sitting on a shelf for too long or you are stocking out faster than you can produce. That information will help you reduce costs related to inventory and manufacturing, while aiding you in having more cash on-hand for meeting your obligations.
Businesses that effectively manage their liquidity are able to survive on the market. The main goal of liquidity management is to help small business owners maintain a positive cash flow. When a cash flow is good, companies can meet all of their responsibilities and pay their dues without having to go into debt.