Odhiambo Ocholla
Liquidity is the availability of funds, or assurance that funds will be available, to honour all cash outflow commitments on and off-balance sheet as they fall due. These commitments are met through cash inflows, supplemented by assets readily convertible to cash or through the institution’s capacity to borrow.
Liquidity can also be defined as a firm’s ability to pay its short-term debt obligations. The risk of illiquidity increases if principal and interest cash flows related to assets, liabilities and off-balance sheet items are mismatched.
Management need to be responsible for managing liquidity and address liquidity issues within the context of a reasonably expected business conditions. However, since liquidity determines the day-to-day viability of an institution, it must remain the principal consideration of asset/liability management.
Sound liquidity management involves managing assets and liabilities on and off-balance sheet, both as to cash flow to ensure that cash inflows have an appropriate relationship to cash outflows.
Liquidity planning
This needs to be supported by liquidity planning, which assesses potential future liquidity needs, taking into account changes in economic, regulatory or other operating conditions. Such planning involves identifying known, expected and potential cash outflows and weighing alternative asset/liability management strategies to ensure that adequate cash inflows will be available to the company to meet these needs.
Managing working capital tightly and using the liquidity you generate to reduce debt is still the best liquidity strategy.
Companies should have prudent liquidity management to honour all cash outflow commitments both on- and off-balance sheet on an ongoing daily basis thus avoid raising funds at market premiums or through the forced sale of assets.
Although the particulars of liquidity management will differ among institutions, depending upon the nature and complexity of their operations and risk profile, a comprehensive liquidity management programme requires, establishing and implementing sound and prudent liquidity and funding policies.
Current economic slowdown presents threat to most companies liquidity position. When companies ask for loans, commercial banks now examine their risks more rigorously. Companies need to be informed of their current liquidity position and plan accurately.
It’s not unusual for companies to have money, but not to know where it is. Such companies might even take out unnecessary loans. This can be avoided with effective liquidity management. Financial ratio analysis will help companies determine how liquid their position is or how successful it will be in meeting its short-term debt obligations. The current ratio will help management determine the ratio of current assets to current liabilities. Current assets include cash, accounts receivable, inventory, and occasionally other line items such as marketable securities. It’s advisable for companies to have more current assets than current liabilities on their balance sheet at all times.
Fast decisions
Effective liquidity management requires an account structure that facilitates fast decisions and simplifies transfers between companies’ accounts. When managing companies’ liquidity you may wish there was no borders or different currencies.
Sound and prudent liquidity policies set out the sources and amount of liquidity required to ensure it is adequate for the continuation of operations and to meet all applicable regulatory requirements for the company.
These policies must be supported by effective procedures to measure, achieve and maintain liquidity. Factors influencing an institution’s operating liquidity may include cash flows and the extent to which expected cash flows from maturing assets and liabilities match the diversity, reliability and stability of funding sources and the capacity to borrow.
Prudent liquidity policies must deal with cash flow uncertainty by carefully controlling the maturity of assets, ensuring assets are readily convertible to cash, or securing sources to borrow funds. Credit lines and funding facilities may also have a role within an institution’s liquidity programme by helping a company protect itself against temporary difficulties that might occur when honouring cash outflow commitments.
Reliance should not be placed on bank overdraft facilities as substitutes for traditional funding sources, as they are generally very short term and costly.
However, a company could implement a disciplined liquidity management process by having good guidelines laid down with proper supervision.
The board of each institution is responsible for the institution’s liquidity. Although the particulars of liquidity management differs among institutions, a comprehensive liquidity management requires establishing and implementing sound liquidity and funding policies.
—Mr. Odhiambo Ocholla is an Investment Banker. Email: nyabolla@gmail.com
