III. LIQUIDITY MANAGEMENT
Managing liquidity is a fundamental component in the safe and sound management of companies. Sound liquidity management involves prudently managing assets and liabilities (on and off-balance sheet) to ensure that cash inflows can meet the approaching size of cash outflows. Therefore the process of liquidity planning, which assesses potential future liquidity needs, considering various possible changes in market, political, regulatory, and other external or internal factors are important.
The objectives of liquidity management are:
1. Scheming cash outflow commitments (on- and off-balance sheet)
2. Avoiding excess funding costs
3. Fulfilling liquidity requirements.
The implementation of liquidity management will depend upon the nature and complexity of the business and risk, however every comprehensive liquidity management program requires:
1. Establishing and implementing sound and prudent liquidity policies
2. Developing and implementing effective systems and procedures to monitor, measure and control liquidity requirements and position.
Management of liquidity should be not only in local currency denomination but also included foreign currencies if the company also conducts business in foreign currencies. However the distinctions between the management of liquidity in local and in other currencies should be done.
3.1 Liquidity Policies
Liquidity policies define the sources and amount of liquidity required to ensure that liquidity is adequate to guarantee the continuation of operations and to meet all applicable regulatory requirements. These policies include operating liquidity and strategic liquidity supported by effective procedures to measure, achieve and maintain liquidity.
3.1.1 Operating Liquidity
Operating liquidity is conducted to meet day-to-day cash outflow obligations in time horizon about one month. It should take into account the factors, which influence liquidity needs as well as the various sources of liquidity.
Since it is not sensible to hold too much liquid assets due to potential loss of earnings relative to investment opportunities, the primary objective should be addressed to ensure the quality of investment and its convertibility to cash.
Factors influencing operating liquidity needs are:
1. Level of mismatch between current asset and liability cash flows
2. Unrealizable cash flows resulting from mortgage renewals or maturity defaults
3. Liability requirements, such as death claim settlements and withdrawals prior to contract maturity
4. Commitments, such as reinsurance settlements, capital purchases, or mortgage funding.
To meet those needs, the policy should define the mix and priority in optimizing funding sources. Therefore the direct and indirect cost of the funds has to be taken into account as well the potential for creating an interest rate risk. The funding sources include:
1. Liquid assets (i.e., cash, money market instruments, and other marketable instruments)
2. Bank lines of credit
3. Premium income
4. Other borrowing.
Operating liquidity is considered adequate if the approaching cash inflows, supplemented by assets readily convertible to cash and by the ability to borrow, are sufficient to meet the approaching cash outflow obligations.
3.1.2 Strategic Liquidity
Strategic liquidity considers liquidity needs on a longer-term basis and be aware of the possibility of various unexpected business conditions. Strategic liquidity is important because of its potential effect on the ultimate viability of the company.
Considering the long-term basis, liquidity management must consider the long-term obligations. The policy should address the future liquidity needs, with regards to current and potential future external and internal environments, such as:
1. The economic and market conditions
2. The regulatory and political environment
3. Strength of the company and its ability to borrow when needed
4. Asset/liability management strategies
5. Concentration of risk.
The liquidity policy should address the corporate objective in terms of its ability to withstand cash demand. This could be expressed in terms of the amount of liquid assets deemed sufficient to support potential cash demands under adverse conditions. It should also ensure that a plan could be put in motion in the event of a liquidity crisis. The policy should include a borrowing policy, which may be used to manage any cash flow shortfall if the borrowing may not be available when needed.
The liquid assets will not only include the assets defined in the Operating Liquidity section but would also include any other assets where the cash may be realizable, over a certain period of time, even if at an economic loss.
The liabilities should also be examined as to their liquid nature from the policyholders' point of view. Some products will not include any cash out privilege; others will include various adjustments or no adjustments. Also, various settlement periods may be used. These product features should be reflected in the need for liquid assets.
Estimating liquidity needs can be conducted calculating future changes over time in assets and liabilities from past experience and future expectations.
Change in asset could be due to increasing or decreasing of inventory, fixed asset and other assets because of the investment or divestment conducted by an enterprise. If an enterprise for example decides to invest in new machine, so estimated asset will higher and there is positive change in asset, which means cash outflow. Contrarily if it decides to sell the machine, estimated asset will be lower and cause negative change in asset, which means cash inflow.
Change in liabilities could be due to increasing or decreasing of account payables, credit and other liabilities such as pre-paid tax and so on. If an enterprise plans to pay its credit or tax, estimated liabilities will be lower, which means cash outflow. Contrarily if it receives credit from bank or suppliers, estimated liabilities will be higher, which means cash inflow.
In order to control the implementation of liquidity policy each company needs to develop and implement effective and comprehensive procedures and information systems to manage and control liquidity in line with its liquidity policies appropriate to the size and complexity of the company's activities. The control is normally conducted by Internal audits to:
1. Ensure liquidity policies and procedures are being adhered
2. Ensure effective controls apply to managing liquidity
3. Verify the adequacy and accuracy of management information reports.
3.2 Liquidity Ratio
Managing liquidity is a fundamental component in the safe and sound management of companies. Sound liquidity management involves prudently managing assets and liabilities (on and off-balance sheet) to ensure that cash inflows can meet the approaching size of cash outflows. Therefore the process of liquidity planning, which assesses potential future liquidity needs, considering various possible changes in market, political, regulatory, and other external or internal factors are important.
The objectives of liquidity management are:
1. Scheming cash outflow commitments (on- and off-balance sheet)
2. Avoiding excess funding costs
3. Fulfilling liquidity requirements.
The implementation of liquidity management will depend upon the nature and complexity of the business and risk, however every comprehensive liquidity management program requires:
1. Establishing and implementing sound and prudent liquidity policies
2. Developing and implementing effective systems and procedures to monitor, measure and control liquidity requirements and position.
Management of liquidity should be not only in local currency denomination but also included foreign currencies if the company also conducts business in foreign currencies. However the distinctions between the management of liquidity in local and in other currencies should be done.
3.1 Liquidity Policies
Liquidity policies define the sources and amount of liquidity required to ensure that liquidity is adequate to guarantee the continuation of operations and to meet all applicable regulatory requirements. These policies include operating liquidity and strategic liquidity supported by effective procedures to measure, achieve and maintain liquidity.
3.1.1 Operating Liquidity
Operating liquidity is conducted to meet day-to-day cash outflow obligations in time horizon about one month. It should take into account the factors, which influence liquidity needs as well as the various sources of liquidity.
Since it is not sensible to hold too much liquid assets due to potential loss of earnings relative to investment opportunities, the primary objective should be addressed to ensure the quality of investment and its convertibility to cash.
Factors influencing operating liquidity needs are:
1. Level of mismatch between current asset and liability cash flows
2. Unrealizable cash flows resulting from mortgage renewals or maturity defaults
3. Liability requirements, such as death claim settlements and withdrawals prior to contract maturity
4. Commitments, such as reinsurance settlements, capital purchases, or mortgage funding.
To meet those needs, the policy should define the mix and priority in optimizing funding sources. Therefore the direct and indirect cost of the funds has to be taken into account as well the potential for creating an interest rate risk. The funding sources include:
1. Liquid assets (i.e., cash, money market instruments, and other marketable instruments)
2. Bank lines of credit
3. Premium income
4. Other borrowing.
Operating liquidity is considered adequate if the approaching cash inflows, supplemented by assets readily convertible to cash and by the ability to borrow, are sufficient to meet the approaching cash outflow obligations.
3.1.2 Strategic Liquidity
Strategic liquidity considers liquidity needs on a longer-term basis and be aware of the possibility of various unexpected business conditions. Strategic liquidity is important because of its potential effect on the ultimate viability of the company.
Considering the long-term basis, liquidity management must consider the long-term obligations. The policy should address the future liquidity needs, with regards to current and potential future external and internal environments, such as:
1. The economic and market conditions
2. The regulatory and political environment
3. Strength of the company and its ability to borrow when needed
4. Asset/liability management strategies
5. Concentration of risk.
The liquidity policy should address the corporate objective in terms of its ability to withstand cash demand. This could be expressed in terms of the amount of liquid assets deemed sufficient to support potential cash demands under adverse conditions. It should also ensure that a plan could be put in motion in the event of a liquidity crisis. The policy should include a borrowing policy, which may be used to manage any cash flow shortfall if the borrowing may not be available when needed.
The liquid assets will not only include the assets defined in the Operating Liquidity section but would also include any other assets where the cash may be realizable, over a certain period of time, even if at an economic loss.
The liabilities should also be examined as to their liquid nature from the policyholders' point of view. Some products will not include any cash out privilege; others will include various adjustments or no adjustments. Also, various settlement periods may be used. These product features should be reflected in the need for liquid assets.
Estimating liquidity needs can be conducted calculating future changes over time in assets and liabilities from past experience and future expectations.
Change in asset could be due to increasing or decreasing of inventory, fixed asset and other assets because of the investment or divestment conducted by an enterprise. If an enterprise for example decides to invest in new machine, so estimated asset will higher and there is positive change in asset, which means cash outflow. Contrarily if it decides to sell the machine, estimated asset will be lower and cause negative change in asset, which means cash inflow.
Change in liabilities could be due to increasing or decreasing of account payables, credit and other liabilities such as pre-paid tax and so on. If an enterprise plans to pay its credit or tax, estimated liabilities will be lower, which means cash outflow. Contrarily if it receives credit from bank or suppliers, estimated liabilities will be higher, which means cash inflow.
In order to control the implementation of liquidity policy each company needs to develop and implement effective and comprehensive procedures and information systems to manage and control liquidity in line with its liquidity policies appropriate to the size and complexity of the company's activities. The control is normally conducted by Internal audits to:
1. Ensure liquidity policies and procedures are being adhered
2. Ensure effective controls apply to managing liquidity
3. Verify the adequacy and accuracy of management information reports.
3.2 Liquidity Ratio
Liquidity ratios focus on the ability to pay bills when they come due. Bankers and suppliers use them to measure the creditworthiness. If the ratios remain relatively high, it shows too much capital may be invested in liquid assets and too little to be devoted to increasing shareholder value. If they remain relatively low, it indicates the sufficiency of liquidity to meet ongoing financial obligations.
The ratios normally used to measure liquidity conditions are: current ratio, quick ratio, working capital, days’ sale receivables, receivables turnover, days’ sale inventory and inventory turn over.
Current Ratio = Current Assets/Current Liabilities
Current ratio is determined by current assets divided by current liabilities, which measure the ability to meet current liabilities out of its current assets. The norm is usually an average of two to one. A shorter operating cycle will result in a lower current ratio whereas a longer operating cycle will result in a higher current ratio.
Quick Ratio = (Current Assets - Inventory)/Current Liabilities
Quick Ratio = (Current Assets - Inventory)/Current Liabilities
The acid test ratio (Quick ratio) is computed by current assets minus inventory divided by current liabilities. Thus this relates the most liquid assets to current liabilities. This is the most stringent test of liquidity. The usual guideline for the ratio is one to one. Short-term creditors will use this as an indication of the ability to meet its short- term debt immediately, therefore a company will have a greater difficulty borrowing short-term funds if it has a low quick ratio.
Working Capital = Current Assets - Current Liabilities
Working capital is defined as current assets minus current liabilities. It is needed to determine the short-term solvency of a firm calculate this ratio. Working capital is also important, since some loan agreements or bond indentures contain stipulations concerning minimum working capital requirements.
Working Capital = Current Assets - Current Liabilities
Working capital is defined as current assets minus current liabilities. It is needed to determine the short-term solvency of a firm calculate this ratio. Working capital is also important, since some loan agreements or bond indentures contain stipulations concerning minimum working capital requirements.
Day’s sales Receivables = Receivables/Daily Average Net Sales
Days' sales in receivables relates the amount of accounts receivable to the average daily sales computed by gross receivables divided by average net sales per year. It will be compared to the credit terms to analyse if the firm is managing its receivables efficiently.
Account Receivables Turnover = Net Sales/Average Receivables
Accounts receivable turnover indicates the liquidity of receivables. This ratio is measured in times per year and is computed by net sales divided by average gross receivables but can also be expressed in days by average gross receivables divided by average net sales for the year.
Days’ sales Inventory = Inventory/Daily Average COGS
Inventory are a significant asset of most firms as they also indicate the short-term debt paying ability. Days' sales in inventory show the number of days that will take to sell current inventory. It is calculated by dividing ending inventory by a daily average of cost of goods sold.
Inventory Turnover = COGS/Average Inventory
Inventory are a significant asset of most firms as they also indicate the short-term debt paying ability. Days' sales in inventory show the number of days that will take to sell current inventory. It is calculated by dividing ending inventory by a daily average of cost of goods sold.
Inventory Turnover = COGS/Average Inventory
Inventory turnover is calculated by cost of good sold divided by average inventory. This forecasts the liquidity of the inventory expressed as times per year. It is also needed to utilize effective inventory control. Too high might decrease sales due to not enough inventory and to low indicates a possible problem with overstocking or obsolescence and the cost associated with carrying such inventory.
3.3 Liquidity Risk
Liquidity risk is the current and prospective risk to earnings or capital arising from inability to meet the obligations when they come due without incurring unacceptable losses. Liquidity risk includes the inability to manage unplanned decreases or changes in funding sources. It can also arise from the failure to recognize or address changes in market conditions that affect the ability to liquidate assets quickly and with minimal loss in value. The risk of liquidity increases if principal and interest cash flows related to assets, liabilities and off-balance sheet items are mismatched.
Liquidity risk should be managed in quantitative and qualitative way. Several indicators are used to assess quantity of liquidity risk, which are accorded the rating.
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