Source and Factors affecting Liquidity

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

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:

• Available cash balances. The liquidation of near-cash securities, investment income, and bank balances are three examples.
• Short-term funds. These consist of the company’s short-term investment portfolios, trade credit, and bank lines of credit.
• Free cash flows. These are operating cash flows after taxes, less short- and long-term investments.
• This demonstrates how well the organization’s cash management processes are working. A firm’s free cash flow will be more limited the more decentralized the company is.

Secondary Sources of Liquidity

Secondary sources of liquidity include:

• Negotiating debt contracts to reduce the burdens of high interest; payments, or principal repayment; 
• Liquidating assets; and
• Filing for bankruptcy protection and reorganization.

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 worsens and leads to liquidity being provided at a higher cost than usual.

Drags and Pulls on Liquidity

Drag on Liquidity

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:

• Uncollected receivables;
• Obsolete inventory; and
• Tight credit.

Pull on Liquidity

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:

• Making payments early;
• Reduced credit limits;
• Limits on short-term lines of credit; and
• Low liquidity positions.

Question

Which of the following are most likely primary sources of liquidity?

1. Negotiating debt contracts and liquidating assets.
2. Ready cash balances and short-term funds.
3. 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 of 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.