Working Capital

Reducing Liquidity Risk With Conscious Cash Flow Management

1 December 2022
The C2FO Team
liquidity risk management

To prevent a liquidity crisis, business owners need to recognise the sources of risk and know how to carefully monitor, manage and optimise key processes.

Conscious cash flow management is key to running a successful business. But it can be challenging for many small to mid-sized companies. In fact, according to an Intuit QuickBooks study, 57% of UK's small businesses have cash flow issues. This is why business owners must ensure that monitoring and managing liquidity is a priority.

Liquidity represents a company’s financial health and its capacity to convert assets to cash. In short, it’s a measure of a business’s ability to meet its short-term operating costs and pay its debts. This is the extent to which an organisation can cover its current obligations, without risking extensive losses. Unless a business has processes in place to ensure sound cash flow and liquidity management, it may face liquidity issues and ultimately become insolvent.

With that in mind, it’s important for business owners to understand and be keenly aware of what liquidity risk is and what causes it. In this post, we’ll define liquidity risk and its sources, and provide some tips for how you can monitor and manage your finances to prevent risk.

What is liquidity risk?

Liquidity risk is defined as the risk of incurring losses resulting from an inability to meet payment obligations on time or from being unable to do so at a sustainable cost. Liquidity risk occurs when a business cannot meet its short-term debt obligations.

what is liquidity risk

Sources of liquidity risk

Liquidity risk comes in many forms. Here are five sources to watch for.

POOR CASH FLOW MANAGEMENT 

Cash flow is the lifeblood of a business, so managing it can mean the difference between a business that’s successful and one that fails. Cash flow management entails carefully tracking and forecasting the money coming into your business (inflows) and monitoring it against expenses (outflows) such as bills, debt payments, payroll and rent. Effective cash flow management provides complete visibility into potential cash flow and liquidity challenges and opportunities. These insights can help you make changes to avoid cash flow and liquidity issues before they come to fruition.

UNFORESEEN MARKET CONDITIONS

Changes in the economy impact all businesses, although small and mid-sized businesses often feel the effect of shifting market conditions faster than larger enterprises. Unexpected disruptions can cause an immediate economic downturn that can have a severe and lasting impact on businesses. For example, lockdowns in response to the global COVID-19 pandemic triggered a dramatic decline in sales and resulted in a near-instantaneous liquidity crisis for many businesses. 

UNEXPECTED CAPITAL EXPENDITURES

Unlike operational expenditures, which include costs such as wages, taxes, insurance and equipment maintenance, capital expenditures refer to money spent to purchase or upgrade fixed assets such as equipment, technology or real estate. It’s important to have an effective plan in place for fixed assets. For example, when a business unexpectedly needs to pay for expensive repairs or replace equipment, and doesn’t have an emergency fund, a warranty in place or adequate insurance to cover the cost, it can put significant pressure on its budget and liquidity.

INABILITY TO QUALIFY FOR FINANCING 

A less-than-stellar credit history can be a challenge for businesses attempting to secure financing. Interest rates and payment terms are largely based on your credit score and are typically more restrictive for those with a lower credit rating. Since poor credit, or a short business credit history, can affect your ability to obtain financing or obtain it at reasonable and competitive rates, it can restrict cash flow, and, in turn, your liquidity. To improve your eligibility for financing, and keep your accounts in good standing, it is crucial to pay your creditors on time and periodically check your credit reports for irregularities or errors that could negatively impact your rating. 

LIMITED PROFITABILITY

Low profitability is one of the biggest reasons companies experience cash flow problems. While cash flow and profit are two different things, a company’s net profit has a direct impact on its cash flow. It’s not uncommon for businesses to dip into cash reserves to remain operating when profit margins are tight. If a business doesn’t make changes to improve or protect margins, and increase its profits, it will eventually deplete its cash reserves and face liquidity challenges. For example, a company experiencing pressure on its margins could increase prices. Or a company with several outstanding invoices could leverage technology to offer incentives such as early payment to improve its finances.

how to measure liquidity risk

How to measure and prevent liquidity risk

One significant aspect of monitoring and managing liquidity risk is recognising the signs of a liquidity problem. You should also be able to measure the extent of the liquidity risk so you can take action to mitigate or prevent a crisis. 

Here are some helpful financial metrics and tactics you can use to measure and manage your liquidity risk. 

USE THE CURRENT RATIO METRIC

The current ratio, also known as the working capital ratio, is a basic metric of liquidity. It indicates how capable a company is of meeting its current or short-term financial obligations. It compares a business’s current assets to its current liabilities, and is expressed as:

working capital ratio

For example: If the sum of the current assets on your balance sheet is £100,000 and current liabilities are £50,000, the working capital ratio would be £100,000 / £50,000 = 2.

Generally, a working capital ratio of less than 1 is considered indicative of potential future liquidity problems, while a ratio of 1.5 to 2 indicates a company is stable in terms of liquidity.

FORECAST CASH FLOW

Cash flow forecasting, another way to assess liquidity, predicts your business’s cash inflows and outflows over a predetermined period of days, weeks, months or quarters. This enables you to make payments on time, plan for growth and predict cash shortages so you can make proactive and informed financial decisions.

Maintaining an accurate cash flow forecast is a fundamental way to track liquidity risk so you can take steps to mitigate and avoid an impending crisis. Note that even when profitability is high, you could be at risk of cash shortages if payments are delayed in accounts receivable.

TRACK AND OPTIMISE WORKING CAPITAL

Fluctuations in business can have a big impact on the net working capital and financing requirements of a company. Business leaders, especially finance managers, should have a solid understanding of how to calculate and monitor key working capital metrics to identify and flag potential challenges, and to proactively take action to optimise and increase working capital.

Net working capital is one of the most important metrics to track because it indicates your company’s liquidity, whether you have the capital to cover your short-term costs and if you are well-positioned to invest in growth. To calculate your business’s net working capital, you need to subtract your total current liabilities from your total current assets. The formula is:

net working capital formula

Positive net working capital (greater than zero) typically indicates that your company is not facing liquidity risk and can even potentially invest in growth opportunities. Conversely, a negative net working capital figure (lower than zero) can represent liquidity risk and be a sign that you need to optimise working capital or apply for financing to avoid liquidity problems.

MONITOR YOUR CASH CONVERSION CYCLE

Another way to recognise potential liquidity issues is to keep an eye on your cash conversion cycle (CCC). This is so you can accelerate it to improve cash flow and ease pressure on your liquidity when you need to. The cycle measures the average number of days it takes to convert your inventory and other resources into cash flow. It takes into account the amount of time it takes you to sell inventory (days inventory outstanding, or DIO), the time you need to collect receivables (days sales outstanding, or DSO) and the time you have to pay your bills (days payable outstanding, or DPO). This is the formula:

cash conversion cycle

Your cash conversion cycle can provide you with insight into how long it takes your business to realise cash flow from your investments in sales and production processes. A lower number usually indicates that the business is efficient in managing its operations. 

To shorten the cash conversion cycle, you need to improve one or more of its components by selling inventory more quickly, collecting revenue more promptly or paying bills more slowly. Leveraging an early payment programme like C2FO’s can help you reduce DSO, increase cash flow and reduce liquidity risk.

The takeaway

Without sufficient liquidity, businesses can struggle to pay bills, invest in growth or obtain financing. At worst, they risk insolvency. To prevent these challenges, you need to thoroughly understand the sources of liquidity risk and how to manage your business’s finances. Ultimately, to avoid liquidity risk, you need to ensure your operating cycle, cash flow, working capital and other financial metrics are consciously managed at all times.

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