Potential Risks due to Poor Corporate ...
Liquidity management describes a company’s ability to generate cash when needed to meet its short-term obligations. Effective liquidity management means that a company can manage its major sources of liquidity efficiently. Although these major sources tend to vary from one company to another, they typically include primary and secondary sources of liquidity.
Primary sources of liquidity refer to funds that are readily accessible to a company at a relatively low cost. They can be held as cash or cash equivalents and include:
Secondary sources of liquidity include:
Using secondary sources of liquidity can impact a company’s financial and operating positions, unlike primary sources of liquidity, which usually have no such impact. Using secondary sources of liquidity can also signal that a company’s financial health is worsening and lead to liquidity being provided at a higher cost than usual.
The timing of cash receipts and disbursements can significantly affect a company’s liquidity position. When receipts infrequently occur, especially after payments are made, a ‘drag on liquidity’ occurs due to the decreased availability of funds. Drags on liquidity include:
Additionally, when disbursements are paid too early, a ‘pull-on liquidity’ occurs because companies will be forced to spend money before receiving funds from sales that could cover their obligations. Pulls on liquidity include:
Question
Which of the following are most likely primary sources of liquidity?
- Negotiating debt contracts and liquidating assets.
- Ready cash balances and short-term funds.
- Filing for bankruptcy and cash flow management.
Solution
The correct answer is B.
Readily available cash balances and short-term funds are examples or primary sources of liquidity.
A is incorrect. Negotiating debt contracts and liquidating assets are examples or secondary sources of liquidity.
C is incorrect. Whereas cash flow management is a primary source of liquidity, filing bankruptcy is a secondary source of liquidity.