Liquidity is one of the important financial parameters to judge the financial health of a company. It has a direct impact on the day-to-day operations and the company’s dealings with third parties.
Lenders determine the liquidity position by considering financial ratios viz., Current Ratio, Quick Ratio, and Cash Ratio. These ratios determine the company’s ability to meet up with its short-term payment obligations. Lenders, Analysts, Creditors, and others look at these ratios to judge the liquidity position.
Although liquidity is a short-term position; a tight liquidity position for a prolonged period could impact the solvency of the company. Working capital issues will put restraints on the rest of the business as well. It’s relevant to take measures to strengthen the liquidity; some of the steps could be as below:
1) Increase the average life of the bank facilities: A move towards longer debt maturities retains the cash with the company, hence, improving the liquidity ratios and in turn strengthening the liquidity.
2) Reducing the cash conversion cycle (CCC): Cash Conversion Cycle is the length of time that a company uses to sell inventory, collect receivables, and pay its payables. The shorter the CCC, the better the liquidity of the company. CCC can then be reduced by efficient inventory management, and effective collection process, and a longer credit period.
3) Getting rid of non-core assets: Assets that are not related to the core activities of a company could be sold to unlock the capital tied up in such assets and improve the liquidity.
4) Buffer of Facilities: Companies should maintain a buffer of Working Capital and Revolving facilities that are around 30% over and above the peak requirements of such facilities. The buffer facilities could be one of the sources of liquidity. Lenders would charge a commitment fee on such facilities; however, the companies should absorb this cost as a cost to maintain liquidity.
5) Control on costs: A control on costs/ overheads would improve the liquidity, however, care should be taken that a necessary cost that would impact the business operations is not sliced off.
6) Cash management system: Efficient cash management system offered by banks tends to improve liquidity by sweeping and pooling cash that was unutilised, efficient payment mechanism, and receivable management.
7) Increase profits by process automation: Improvement in profit would lead to a better liquidity position. Some of the processes could be automated to save costs and add to the profits.