Why is liquidity planning important?

The liquidity of a company plays a decisive role in financial management. In the short term, the company's liquidity is more important than making a profit. To avoid insolvency, the company must be able to have sufficient liquidity at all times. Sufficient liquidity is essential for survival, particularly in difficult economic times. Serious financial and liquidity planning is absolutely necessary to ensure this. Numarics explains why and how.

Why is liquidity planning needed?

From a legal perspective, liquidity planning for certain types of companies (in particular for joint stock companies (AG) and limited liability companies (GmbH)) is enshrined in law. According to Art. 716a (1) OR, the organization of accounting, financial control and financial planning are among the non-transferable and indiscriminate tasks of the Board of Directors. Liquidity planning is one area of financial planning mentioned in the Act. From an economic point of view — and this now applies to all companies and especially to start-ups — a company needs liquidity planning in order to be able to ensure solvency at all times.

Liquidity comes from Latin and means “liquid.” In terms of a company, “liquid” means the liquid means of payment available in a company, such as cash or bank deposits (in business terms, you could also include the short-term, guaranteed credit limits that have not yet been retrieved). A “liquid” company can therefore pay all pending invoices on time.

If, on the other hand, you don't plan a company's short-term liquidity, this can quickly lead to problems. In a first phase, this is usually not yet dramatic, but for example, you can no longer pay bills on time. This results in initial reminders. Over time, reminders accumulate, which can also result in additional reminder fees. If the situation worsens, business partners may only deliver against prepayment or may even completely end a business relationship. By then, at the latest, your own service delivery process will also be affected by the liquidity crisis. If effective countermeasures are not taken in time in such a case, this almost inevitably leads to debt collection and, in some cases, insolvency. Reliable liquidity planning is therefore essential for every company. However, it should not be forgotten that even careful financial planning does not always protect against unexpected developments — it is and remains a plan.

A pleasant aspect of liquidity planning can be that you identify excess liquidity. In this case, management must consider how to deal with this situation and what they intend to do with the free funds. This decision is linked to the question of whether the excess liquidity is short-term or whether this situation is of a long-term nature.

How does liquidity planning work?

In principle, liquidity planning is a very simple matter. You start with the current liquidity (balance of liquid assets) and ask yourself what cash inflows can the company expect and what outgoing payments are due. This results in the new cash equivalents. You can do this on a daily, weekly or monthly basis; it depends on the type of business. In most companies, the short-term liquidity plan is based on a monthly basis and plans to ensure liquidity in the sense of an early warning system. If bottlenecks are identified, effective measures must be taken at an early stage.

Incoming payments result primarily from sales of products and services. It should be noted that not all (or no) sales are made in cash, but initially represent a claim against a customer. In this case, payment will only be received late. Assumptions must be made for the time sequence, for example 60% of the invoice amounts in the following month, a further 30% within two months, a further 7% within three months and the remaining 3% are considered unrecoverable. These assumptions should be as realistic as possible, but still cautious and are based on experience.

Capital increases or borrowing also result in an inflow of liquid funds.

Outgoing payments consist, for example, of the following (the list is not exhaustive):

• Costs such as the purchase of goods (raw materials, commercial goods, auxiliary materials such as packaging) — these costs are typically variable in relation to the provision of services — they rise and fall roughly evenly with production volume or turnover,
• personnel costs (including social security and income tax) — depending on the legal structure, personnel costs are fixed costs, but at most, it is possible to structure some of the personnel costs as variable costs (e.g. by personnel on an hourly basis)
• other operating expenses, such as rents including ancillary costs, marketing expenses, travel expenses, various administrative expenses, consulting and legal costs, insurance, leasing payments, etc. — some of these costs are fixed and therefore easy to plan (e.g. rent or insurance), others such as consulting and legal costs are more difficult to plan
• repayment of borrowed capital (bank loans or private loans) including interest service,
• repayment of equity and payment of a dividend,
• Taxes (value added tax and income and capital tax)
• investments — these must be planned precisely, as they usually result in a larger outflow (note: subsequent depreciation of assets then only leads to an expense, but no longer to an outgoing payment),
• Private withdrawals by the entrepreneur, unless these are already included in personnel expenses.

Since liquidity planning is heavily based on experience, it is easier for established companies to develop than for start-ups. The uncertainties are higher here; in particular, sales and their chronological sequence are more difficult to estimate.

Tips for conserving and ensuring liquidity

First things first: Always use liquidity sparingly and question any expenditure.

Based on your financial and liquidity planning, you should identify long-term and short-term capital requirements at an early stage. To do this, contact the bank early on — a bank becomes suspicious when a liquidity bottleneck “suddenly” appears. But if you seek a conversation early on due to serious planning, banks are usually happy to help, because that is the core business of a bank. If you prefer to cover your capital requirements with equity, then remember that a capital increase by equity providers also requires a lead time.

Implement active and effective receivables management. Invoices must be issued immediately after the service has been provided. For long-term work, agree on on-account invoices. If necessary, set incentives for quick payment (discount). Send a payment reminder politely but quickly and decisively as soon as a debtor is in default. For difficult customers, you can work on the basis of down payments or payment in advance.

There are also a few things you can do with regard to the outputs. For example, ask for several offers for services that you purchase. The price differences as well as the terms of payment are sometimes large. And don't be afraid to negotiate the price. Experience shows that a discount is very often possible or payment terms are adjusted.

If there are some costs, it is worth considering whether you can design a part variably. For example, in human resources through the use of freelancers or — depending on the sector — when renting as a function of turnover.

Even when investing, you should carefully consider whether you have to make the purchase now or whether leasing or renting would make more sense. And if you have to make a purchase, then you need to obtain several offers in return. And of course, operating and follow-up costs must also be considered when making purchases.

Should things get tight despite good planning, then these tips can only be checked:

• Short-term increase in the current account limit
• Make full use of payment deadlines for invoices
• Negotiate installment payments or settlement with creditors
• Exploring reductions in personnel costs
• Reduce overtime instead of paying out
• Renegotiate loan repayments
• Check sale of non-essential assets and/or sale and lease back
• Reduce payment deadlines for customers or resort to factoring.

The measures mentioned above are of course not always applicable to every company, but must be examined individually and individually.

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