1. Cash Gets Converted into Inventory
This would include the purchase of raw materials, conversion of raw materials into work-in-progress, finished goods and terminate in the transformation of goods into stock at the end of the manufacturing process. In the case of trading organizations, this phase would be shorter as there would be no manufacturing activity and cash will be converted into stock directly. The phases will, of course, be totally absent in the case of the service organization.
2. Conversion of Inventory into Receivable
In the second phase, the inventory is converted into receivables as credit sales are made to customers. Firms, which do not sell on credit, will obliviously do not consist of the second phase of the operating cycle.
3. Conversion of Receivable into Cash
The last phase thirds represent the stage when receivables are collected, this phase completes the operating cycle. Thus, the firm has involved from cash to inventory, to receivables and to cash again. Thus the process of gaining liquidity is of vital importance. The need and importance of liquidity management are due to the followings points: -
(A) Management of Short-term Solvency
Liquidity or availability of liquid resources gives an indication of the capacity to pay its short-term obligation. This kind of information is valuable for short-term creditors and present and future investors.
(B) Management of the Efficiency of the Credit Department
In the normal course of the business, no firm can strict to cash sales only. Every business concern has to sell on credit if the collection for debtors is very slow then it will affect the quantum of liquid resources. The concern may feel difficulty in paying short-term liabilities. Thus it is very necessary to know the efficiency of collection department and sufficient amount of collection will be hence the liquidity of the concern.
(C) Inter-Firm Comparison
As regard the liquidity we can compare the position of different firms, in the case of paying its short-term liabilities. Thus on the basis of liquidity inter-firm comparison may also be done.
(D) Early Payment to Suppliers
Sufficient liquidity will unable the business to its suppliers immediately. Similarly, the concern may not feel difficulty in acquiring raw materials regularly and consequently, the production activity may be continued without any obstruction.
(E) Benefits of Cash Discount
If we have sufficient liquidity we can get the benefit of cash discount on goods purchase by doing this, the production cost will be decreased and in that case, the business firm may reduce its prices and will be able to compete better.
(F) Payment of Dividend
Due to lack of liquidity, sometimes it happens that business activity is going very smoothly but the concern is not able to pay a dividend. This situation arises when the quantum of credit sales is very high consequently. The business concern is not able to pay a dividend while the profit and loss account show the sufficient profits but if it has sufficient profit and liquidity, we may pay an attractive dividend and the shareholders may get full satisfaction and the prices of the security will also remain static.
(G) Increase in Credit and Capacity of Getting Loans
The institutions, which have sufficient liquid resources, may be treated as an institution of having a good financial position. This type of institution may get loan and advances where needed. Secondly, the institution may be able to run it's manufacturing and trading activity continuously without any difficulty.
(H) Easy Bank Loan
If the concern has sufficient liquid asset, the short-term solvency may be treated as good and banks will hesitate to give short-term or long-term loans. Because the sample of liquid assets over liquid liabilities it treated as a good security by the bank.
(I) To Make Use of Favorable Conditions
If business conditions have a tendency to change and have sufficient liquidity, it can make use of favorable condition and may gain profit. I.e. if there is a probability of price rise in raw materials we can purchase sufficient amount of raw materials. Thus, we can make use of this favorable condition provided that we have sufficient liquid resources.
Sufficient liquid resources will effect psychologically to directors and managers and they will be more inspired to work with zeal. Similarly, if the employees get their salary with allowances in time, they will work more effectively. Thus, sufficient liquid resources physiologically, motivate managers as well as employees and by this, the efficiency of the concern will increase.
(J) Helpful in Payment of Contingencies
In the case of contingent events and contingent trading difficulties we can face them easily, if we have sufficient liquid resources.
(K) Increase in Efficiency
Sufficient liquid resources will effect psychologically to directors and managers and they will be more inspired to work with zeal. Similarly, if the employees get their salary with allowances in time, they will work more effectively. Thus, sufficient liquid resources physiologically, motivate managers as well as employees and by this, the efficiency of the concern will increase.
(L) Increase in Productivity of Fixed Assets
Sufficient liquid resources increase the productivity of fixed assets that is if raw materials and labor are available in sufficient quantity the machine will work at full capacity without liquidity. Fixed assets will be age arises without ammunition. Proper management of liquidity is very important for the success of an enterprise. The manner of management of liquidity to the very large extent determines the successes of the operation of concern.
Constant management is required to maintain appropriate levels in the various working capital accounts. The failure of any enterprise is undoubtedly due to poor management and absence of management skill, shortage of liquidity, so often advanced as the main cause of failure is nothing but the clearest evidence of poor management which is so common. There are many aspects of liquidity which make it an important function of the financial manager, on the one hand, it maintain proper liquidity, while on the other it helps in increasing the profitability of the concern.
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