The Future of Risk Management: Forecasting Liquidity

A liquidity forecast is a prediction of a company or market’s cash flows at some future point in time. On a company or market basis, liquidity forecasting allows companies to pinpoint potential times that available sources of credit would not be able to cover cash shortages. Alternatively, liquidity forecasting also allows companies to identify if there is an excess of liquid assets which can then be utilized for other initiatives. Using a combination of liquidity tools allows companies to measure their liquidity and manage potential excess or insufficient cash in advance. Liquidity can be committed or uncommitted; in times of volatility, uncommitted liquidity may be decreased significantly whereas committed liquidity will stay stable.

While there is a variety of ways to calculate liquidity, a thorough liquidity forecast will have accounted for potential shocks by performing simulations and analyzing various scenarios on both cash flow and availability of liquidity. The most liquid asset a company can have is cash.

A company’s liquidity has many factors. One of the most common determinants of liquidity is cash flow. Cash flow is the difference between inflows and outflows for a company. Since forecasting these is not always accurate, unpredictability can affect actual liquidity. A drag on liquidity occurs when cash inflow is either reduced or delayed and can be caused by, obsolete inventory, bad debt, tight credit, and more. Contrarily, a pull on liquidity occurs when cash outflow increases and can be a result of making payments, reduced credit, and more. A drag or pull decreases a company’s liquidity.