The liquidity of a firm refers to its ability to meet short-term obligations using firm’s assets can be quickly converted to cash. Cash is the most liquid form of asset a firm has. Different assets offer different levels of liquidity. For example a firms inventory is considered a liquid asset but may not be as liquid as other assets such as short-term money market securities that can be converted into cash very quickly.
Liquidity management is the ability of the firm to generate enough cash required to meet the firm’s needs.
Some firms operate in industries or conditions where they always have excess cash and liquidity is not a concern. Instead, there the focus is on how to use this excess cash to maximize the shareholders’ returns.
In other firms, because of the nature of the industry or the firms financial condition, there may be tight liquidity conditions. In such firms, it’s important to effectively manage liquidity to avoid problems.
The various sources of liquidity for a firm can be classified as primary and secondary sources. Let’s take a look at these sources of liquidity:
Primary Sources of Liquidity
The primary sources of liquidity include the sources that a firm uses for its regular daily operations. This includes:
- Cash received from sales
- Collection of receivables
- Short-term investment, and others
- Short-term Funding
- Trade credit from suppliers
- Working capital loans from banks
- Cash flow management
- The firm can also generate working capital by effectively managing its cash.
Secondary Sources of Liquidity
These are the sources of liquidity that are not normally a part of the regular operations. However, in times of need, the firm may use these sources. These include:
- Renegotiating existing debt contracts
- Liquidating short-term and/or long-term assets
- Filing for bankruptcy
Utilizing the secondary sources of funding can impact the company’s financial structure and may even affect its operations. This also indicates that the firm’s financial condition is deteriorating.
Factors affecting a firm’s liquidity position
A firm’s liquidity position is affected by how the cash inflow or cash outflow is affected.
Drags on Liquidity
When the cash inflow is reduced or delayed, it’s referred to as drag on liquidity.
- Bad debt
- Obsolete inventory
- Tight credit: Less or expensive trade credit
Pulls on Liquidity
When the cash out flow increases, it’s referred to as pull on liquidity.
- Making payments fast to suppliers, employees, etc.
- Reduced credit limits by suppliers
- Limits on short-term line soy credit
- Poor liquidity conditions
A firm should identify these pulls and drags on liquidity quickly in order to improve the liquidity position of the firm.