Financial Management Objectives (2) Liquidity

Liquidity expresses the institution’s ability to meet its expected and unexpected short-term obligations when due through the normal cash flow resulting from its sales and collection of its receivables in the first degree, and by obtaining cash from other sources in the second degree.

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Liquidity Concepts

There are two concepts of liquidity:

Quantitative concept
Flow concept

The quantitative concept of liquidity

The quantitative concept is the concept that looks at liquidity through the assets at hand of the enterprise that can be converted into cash at some point during the business cycle of the enterprise. Based on this concept, liquidity is evaluated by comparing the amount of assets that can be converted into cash during the financial period with the cash needs for that period.

This concept is considered narrow for its dependence in assessing liquidity on the amount of assets convertible into cash, as well as its failure to consider the liquidity that can be obtained from borrowing and increasing capital and profits.

The flow concept of liquidity

It is the concept that looks at liquidity as the amount of assets that can be converted into cash during a certain period in addition to what can be obtained from other sources of funds.

Definition of Liquidity

Based on the concepts explained above, the following definitions of liquidity can be made:

Liquidity is the availability of funds when they are needed.
It is the ability to provide funds at a reasonable cost to meet obligations as they become due.
And it is the ability to convert some assets into ready cash within a short period without significant loss.

Liquidity Purposes

The liquidity of the institution in the short term is given all the importance, because the question that is always raised is: What is the value of all good indicators of performance if the existence of the institution itself is threatened by the problem of liquidity?

The availability of liquidity brings many positive advantages, including:

Enhancing confidence in the institution by its dealers and its lenders as well.
Avoid paying a high cost of money if the institution or compan is forced to secure the necessary liquidity for it through borrowing.
Fulfilling obligations when they are due and avoiding bankruptcy. And this is insurance for the continuity of the institution.
Facing the requirements of operation and production.
Facing unexpected deviations in cash flows.
And, facing crises when they occur.
The ability to meet the requirements of growth.
Flexibility in choice because the availability of liquidity at the institution enables it to search for the best source when it wants to obtain it without being restricted to a specific source.
The ability to take advantage of opportunities.
The possibility of obtaining discounts from suppliers.

Liquidity Sources

There are sources of liquidity for each institution, including:

Selling goods and services at the institution for cash.
Converting current assets into cash during the trading cycle.
Sale of other assets for cash.
Use of external sources of cash, such as borrowing.
Increasing the capital or retained earnings without distribution.

The liquidity of the institution and of the asset

In general, a distinction must be made between two concepts here, which are:

Liquidity of the institution: It is its ability to meet its obligations when they fall due, and this means the concept that we referred to earlier.

The liquidity of the asset: It is the speed of converting the asset into ready cash, and it is judged by:

The time required to convert the asset into cash.
Degree of certainty that this asset will be converted into cash without losing its value.

Causes of liquidity problems

Liquidity problems in institutions result from an error in the management of current assets mainly. Or it may be as a result of an error in its composition on the left side of the budget, due to the imbalance between the nature of sources and uses.

More specifically, it can be said that the liquidity problems of institutions can be due to one or more of the following reasons:

The institution’s investment of its money in assets that are difficult to convert into cash in a timely manner.
The lack of synchronization between the dates of fulfillment of obligations and the dates of cash flow for the institution.
An institution realizes a loss in its operations, which leads to the depletion of its resources.
The imbalance between the growth of the institution’s obligations, its service burdens, and the institution’s ability to generate cash from its operations.

Negative consequences of the liquidity problem

The persistence and development of the institution’s liquidity problem leads to several negative results. The first stages lead to:

Reducing the organization’s ability to seize the available opportunities
Missed opportunities to get cash discounts when buying.
Loss of freedom of choice and movement.

As for the advanced stages of the liquidity problem, it can lead to:

The liquidation of some investments and assets at an inappropriate time.
Bankruptcy and liquidation of the institution with the consequent losses to creditors, suppliers and investors.

Liquidity Metrics

There are several measures of liquidity, including:

Current ratio: It measures the adequacy of current assets to cover the short-term debts of the institution.
Quick ratio: It measures the adequacy of current assets, excluding merchandise and advance payments, to cover the short-term debts of the institution.
Net working capital: It measures the quantitative difference between current assets and current liabilities.
Current Assets Turnover: It measures the speed with which current assets are converted into cash.
Accounts receivable and merchandise turnover ratio: It measures the speed at which the institution’s assets are transformed from merchandise and debts to cash.

These measures will be dealt with in detail in the subject of Financial Analysis with Ratios.

Liquidity and Profitability

One of the ultimate financial management objectives, which is to maximize the present value of the organization, is highly influenced by the liquidity and profitability objectives.

The profitability of the institution is achieved through the sufficient operation of the assets of the institution, while the liquidity is achieved through the efficiency in managing the elements of working capital, and in the ability of the institution to obtain short-term and long-term financing.

Liquidity is necessary for the institution to fulfill its obligations and avoid the problems of the risk of bankruptcy and liquidation if liquidity is not available, even for a short period. But also, at the same time, excess liquidity may lead to a reduction in profits as a result of the institution employing part of its funds in investments with low returns.

Profitability is necessary for the institution’s ability to survive and continue, because the invested loss will lead to the erosion of shareholders’ rights and the start of a threat to the rights of creditors, which is not acceptable to them, and will lead them to stop extending the institution with any new financing and work to reduce the old financing where possible. In order to achieve profitability, institutions seek to invest as much of their funds as possible in investments with high returns, which generally contradicts the objectives of financial management in terms of liquidity.

Match between liquidity with profitability

Accordingly, achieving the basic objective of the institution, which is to increase its current value, requires matching between the two objectives of liquidity and profitability, which adds a new dimension to the functions of financial management in the institution, which is to reconcile these two conflicting goals, especially since the reasons for the contradiction between liquidity and profitability are due to the fact that achieving one of them would be at the cost of sacrificing one thing from the other. Increasing liquidity means increasing assets that do not achieve a high return, and this contradicts the goal of profitability and the goal of increasing the current value of the institution. And the increase in profitability requires more investment in less liquid assets, and this itself contradicts the goal of liquidity and exposes the institution to greater risks.

Correlation and conflict with profitability

From the foregoing, it can be said that liquidity and profitability are two concomitant goals of financial management, but they are in conflict. So the financial management of the institution must give special attention to the balance between these two matters, for the significant negative effects that can arise from the imbalance between them, through careful monitoring of cash flows Incoming and outgoing, so that there is no excess liquidity, and at the same time it must direct its investments to the basic goals for which the institution was established without exaggerating the expansion at the expense of liquidity.

It is appropriate to point out that there is no permanent correlation between liquidity and profitability, as both may be achieved together, so the profitability of the institution is high, yet it may suffer from a liquidity crisis, and the opposite may be true.

The impact of liquidity on the continuity of the institution

One of the most important objectives of financial management in organizing and managing the issue of liquidity in the institution is to maintain the continuity of the institution and to keep the risks of financial hardship away from it. If the institution is not able to manage its liquidity properly, it may face a (temporary) financial hardship that can be overcome, but it may face (permanent) financial hardship that is difficult to overcome, which ultimately leads to the liquidation of the institution and the termination of its existence.

Insolvency is defined as the inability of an institution to meet its due obligations on time.

Institutions face two types of financial hardship in their lifetime:

Technical financial hardship

Technical Insolvency, is the situation in which the institution’s assets – as an existing and continuing project – exceed its debts, meaning that the institution has a positive net value, but this institution is not able to meet the obligations that are due on it on time. This may arise from the expansion of investment in assets that are not convertible into cash, or the imbalance between sources and uses or loss.

This kind of hardship can be overcome, especially if the institution’s chances of business and success exist, by rearranging its investments in various types of assets, liquidating what can be dispensed with, maintaining high cash or arranging with creditors to reschedule their debts comfortably.

Real financial hardship

Real financial hardship (or: Real Insolvency), is the situation in which the value of the institution’s assets – as an existing project – is less than its debts. That is, the net value of the project is either zero or a negative value. The real hardship is accompanied by technical hardship, i.e. a problem of liquidity and inability to meet the outstanding obligations on time.

It is difficult to overcome the problem of real financial hardship, so this type of hardship often leads to the liquidation of the institution, especially when the creditors insist on speeding up the liquidation of the institution in order to reduce their losses, because they believe that more waiting may lead to greater losses.

References

Financial Management Encyclopedia, Multi Disciplines Research and Studies Center, 2022