Managing an organizations liquidity, while a relatively simple function, is crucial to ensuring that taxpayer dollars are properly managed. Improper management can lead to ratings downgrades and higher interest rates on bonds, negative press, and frustrated vendors and employees who receive payments that don't clear the bank. Proper liquidity management, however, allows a government to optimize investment income, avoid overdraft fees, and identify irregularities, errors, or fraud.
Although the terms "liquidity management" and "cash-flow forecasting" are often used interchangeably, they are not synonymous. Instead, they go hand in hand. Proper liquidity management requires a good understanding of the organization's cash-flow needs and requirements, and cash-flow forecasting is the art of successfully estimating the magnitude and timing of the organization's cash inflows and outflows--the foundation for managing liquidity.
Cash-flow forecasting forms the basis for successful liquidity management. The key is to have a comprehensive understanding of all of the sources and uses of the organization's liquidity (e.g., cash).
In its simplest form, a cash-flow forecast is nothing more than a projection of periodic (e.g., daily, weekly, monthly, quarterly) anticipated receipts (i.e., cash inflows) and anticipated disbursements (i.e., cash outflows). The net of the receipts (i.e., total inflows less total outflows) is the estimate of the organization's investible cash balances. A positive number represents the amount of investible funds, and a negative number represents the amount of additional amount of cash needed. In the case of a shortfall, the funds manager would need to liquidate an investment or borrow the cash on a short-term basis.
Creating a cash-flow forecasting model requires answers to three very simple questions:
How much cash is available?
When will it become available?
How long will it be available?
In addition to improving investment earnings and ensuring that sufficient cash available for disbursements like payroll and accounts payable, cash-flow forecasting acts as an early warning system. It can communicate that the organization's cash-flow characteristics are changing, warning the organization about impending budget problems. At the same time, it can enhance interdepartmental cooperation, as the departments are engaged in the process to gain a better understanding of their cash flows, project requirements, and operational needs.