Liquidity and cash budgets

Two of the most important aspects in your cash management program, for your small business are to clearly understand what liquidity is and how it relates to your cash budget. Liquidity is often overlooked, and sometimes misunderstood. This can be a serious mistake, for a small business with limited assets, and cash flow. It should be understood that focusing on liquidity may come more naturally to a CEO, than to an accountant who is trained to practice accrual accounting. This is because when your business is just starting up, you essentially run it out of a check book, which is an example of cash accounting. Then as long as there is cash in the account, your business is solvent. However, as your business becomes more complex, you will have to adopt financial accounting. This means that you have to keep a focus on liquidity and cash management, even though you track net income through financial accounting.

It is important to understand that there are methods you can use to measure your liquidity. One of the most commonly used is financial ratio analysis. This will help you determine how liquid your firm is, or how successful it will be in meeting its short-term debt obligations. The current ratio will help you determine the ratio of your current assets to your current liabilities. Current assets include:

• Cash


• Accounts receivable


• Inventory


• Other line items such as marketable securities

Remember that you need to have more current assets than current liabilities, on your balance sheet at all times. This quick ratio will allow you to determine if you can pay your short-term debt obligations, or current liabilities, without having to sell any inventory. It's important for a business to be able to do this because, if you sell have to sell inventory to pay bills that means you have to find a buyer for that inventory and finding a buyer is not always easy or possible. There are also other measures of liquidity that you can use to determine your cash position.

Another important aspect of cash management is keeping a cash budget. Most businesses should prepare monthly cash budgets to keep track of their cash. Financial experts recommend that cash budgets should be done six to twelve months, in advance to project cash needs. When a cash budget is done this way it will capture the timing difference between the profit you see on the income statement, and the cash that is actually coming into and flowing out of the business.

It is crucial to remember that the purpose of the cash budget is not to set targets for cash, but to anticipate needs. If you prepare cash budgets 6 - 12 months in advance and your needs change, then you can change your cash budgets. It is important to keep them up to date, because the cost of running low on cash in a business is high. In addition, you should always prepare your budgets conservatively, to anticipate and be able to address "what-if" scenarios. You can use them to test different possible future scenarios.

You ca also use financial ratio analysis to check out your position regarding inventory and accounts receivables. This can dramatically affect your cash budget. Inventory turnover ratios can tell you if your inventory is obsolete, or if you are selling so fast you are stocking out. Accounts receivable ratios, such as day's sales outstanding, can tell you how fast your credit customers are cleaning up their accounts. Remember that once you determine the position of your inventory and receivables, you can take the appropriate actions to adjust the situations and have more cash coming in to your firm. You can then in turn have that reflected accurately on your cash budget.