Types of Financing Methods
Every source of capital has different risks for the company and the investor.... Read More
The degree to which a corporation can satisfy its short-term obligations using cash flows and assets that it can quickly convert into cash is referred to as liquidity. In this context, liquidity refers to the available cash, borrowing power, and the capability to turn other assets into cash.
Liquidity management describes a company’s ability to generate cash, whenever there is a need, 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 include primary and secondary sources of liquidity.
Primary liquidity sources 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 they include the following:
Primary sources of liquidity demonstrate how well an organization’s cash management processes are working. The more decentralized a company is, the more limited a firm’s free cash flow is.
Secondary sources of liquidity include:
Using secondary sources of liquidity can impact a company’s financial and operating positions. In this respect, secondary liquidation sources are 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. Consequently, under such circumstances, liquidity is 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, a ‘pull-on liquidity’ occurs when disbursements are paid too early. This is because companies will be forced to spend money before receiving funds from sales. Pulls on liquidity include:
Question
Which of the following are most likely primary sources of liquidity?
A. Negotiating debt contracts and liquidating assets.
B. Ready cash balances and short-term funds.
C. Filing for bankruptcy and cash flow management.
Solution
The correct answer is B.
Readily available cash balances and short-term funds are examples of 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.