The Importance of Liquidity Management

Poor cash flow management is the number one reason businesses fail – outpacing competition, staffing issues, and even a lack of demand for their products. In many cases, these businesses fail because they do not have enough cash available at a pivotal moment. This tipping point could be a missed expansion opportunity, an emergency that depletes reserve funds, or an unexpected slowdown in sales.

To avoid these devastating situations, cash managers must accurately forecast income and expenses, while investing in a way that ensures cash is available when required. Balancing these competing needs is a challenge, but a focus on liquidity management can help firms ensure their cash is accessible at pivotal moments.

What is liquidity management and why is it challenging?

Liquidity management is the process of positioning a company’s cash reserves so that it is safe, accessible when needs arise, and growing while waiting to be deployed. In many cases, maintaining accessibility and maximizing returns are contradictory, which can make liquidity management a difficult balancing act.

Why is liquidity management important?

Liquidity management is vital to the health of a business because its goal is to ensure that the company can meet its obligations while maximizing interest income. For example, a company with sufficient liquidity can pay vendors, staff, and debtors on time without disrupting their long-term investments.

On the other hand, poor liquidity management can lead to disastrous results. These include cash flow shortages that could result in defaulting on loans, troubled relationships with vendors, a lower credit rating, and even bankruptcy.

A Recent Example of Poor Liquidity Management

There are many examples of poor liquidity management resulting in devastating losses for businesses in all sectors. One of the most apparent is the recent failure of Silicon Valley Bank [SVB].

SVB experienced a liquidity crunch due in part to heavy investment in long-term Treasury securities. These bonds are backed by the full faith and credit of the U.S. government, so the quality of the investments was not an issue. Instead, the problem arose because the investments did not offer the necessary liquidity.

When interest rates rose, the value of the bank’s bonds fell. Then, an influx of withdrawal requests from struggling tech companies forced the bank to sell bond holdings at a $1.8 billion loss.

As the media began covering the struggles of the bank, frightened depositors rushed to withdraw their funds – leading to the bank’s collapse. In hindsight, many of the problems that faced Silicon Valley Bank could have been prevented with a successful liquidity management plan.

Crafting an Effective Liquidity Management Plan

To create a successful liquidity management plan, companies must balance accessibility needs with return requirements. This often involves separating cash reserves by the timeframe in which they are needed.

Operating Cash

Cash that is needed to meet current obligations – also known as operating cash – should remain accessible at all times. This cash could be used for a variety of purposes such as paying mortgages, rent, utilities payments, employee salaries, and loan payments.

There are several options to invest operating cash but one of the most common is a deposit account such as a checking account. These accounts are highly liquid, and their value does not fluctuate with changes in investment markets.

Deposit accounts are insured up to the $250k FDIC / NCUA limit at each institution. This government insurance protects the principal and accrued interest from bank failure up to the applicable limit.

While these accounts provide maximum liquidity, the government insurance limit can leave a significant amount of a company’s cash at risk. Additionally, the nature of these accounts means they typically pay a lower amount of interest than long-term alternatives.

Fortunately, advances in fintech have solved these complicated issues. With modern deposit management services, companies can access extended government insurance and nationally competitive returns without sacrificing liquidity.

Medium and Long-term Cash

In addition to operating cash, companies often have cash reserves that are not needed immediately. This type of cash could include funds earmarked for future projects or cash intended to help the company take advantage of opportunities as they arise.

When possible, medium and long-term cash should be invested in less liquid investments to capture higher returns. Certificates of Deposit [CDs] are a popular way to achieve a higher rate of return than deposit accounts without sacrificing safety. These features make CDs excellent options for medium term cash.

Like deposit accounts, both the principal and interest invested in CDs are covered by government insurance up to the $250k limit. Banks typically pay significantly higher rates for CDs than deposit accounts because the business agrees to leave the funds in the investment for a specified length of time. Additionally, CD rates are fixed for the term of the investment which allows businesses to lock in high rates when interest rates are elevated and maintain those returns even when market interest rates decline.

In some instances, businesses need to access cash on a set schedule to complete a project or take advantage of changing interest rates. In this case, a CD ladder can help optimize returns while ensuring investments mature when needed.

Today’s deposit management services provide businesses with to access competitive CD rates from across the country along with customized investment plans and CD ladders. Additionally, companies can access extended government protection above the standard limit all in a single account with these services.

Crafting a liquidity management plan often involves collaboration between finance and risk management departments to determine how cash should be split between short- and longer-term investments. Then, companies can partner with an experienced deposit management firm to optimize investments to meet their liquidity needs without sacrificing safety or returns.

Earn More, Risk Less® with Deposit Management by ADM

At the American Deposit Management Co. [ADM], our experienced cash consultants help businesses invest cash to match their liquidity needs. Our deposit management solutions provide next-day liquidity, access to extended government insurance, and nationally competitive returns.

In addition to highly liquid accounts, we also offer CDs and CD ladders for funds that are waiting to be deployed. Best of all, our vast network of financial institutions competes for deposits, so our customers receive nationally competitive returns whether they invest in CDs or more liquid alternatives.

To learn more about how we can help you implement a successful liquidity management plan, contact us today.

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