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How to build a liquidity model


In our previous article, we explained how to prepare a financial model from start to finish, just like the finance teams of major companies and investment analysts from private equity funds and investment banks do. In this article, we will proceed to explain what a liquidity model consists of, the main differences with a financial model, the use cases, and how one can be set up.

The liquidity model

Before we begin, you may be wondering what a liquidity model is, and how it differs from a traditional financial model. Well, the answer is relatively simple, it is a more simplified financial model that aims to analyze a much shorter period of time. As its name indicates, the objective of this financial model is to generally analyze the short term, from 6 months to around a year and a half. The operation of this type of financial model is generally very similar to a long-term financial model commonly used in company valuations. However, this type of model tries to go into much more detail in the possible scenarios and possibilities and their short-term impacts. That is, for example, what happens if a main client goes bankrupt and stops paying us the outstanding invoices? What happens if a payment to a supplier arises, with which we did not count because it has been an extraordinary expense? What happens if the legislation changes and we have to pay a tax that was not foreseen, or if the calculation of the tax made the previous year was wrong and in the coming months we have to pay a very high amount? As you can see, the analysis is quite different from what is usually done in a generic financial model. This type of liquidity analysis tries to anticipate extraordinary situations that could seriously impact a company from the cash point of view, in order to avoid falling into compromised situations.

Who prepares the liquidity model?

Liquidity models are often prepared by people other than generic financial models. Why? Actually, it does not have a clear explanation either, on some occasions the same person who prepares the financial models and the liquidity models can coincide. However, liquidity models are a more corporate analysis. Just as financial models in many cases are prepared by investment banks, and venture capital funds or “private equity” in the analysis of their future investments, liquidity models are one more exercise in corporate finance for a company, that is, a more internal exercise.

It is very common for a liquidity analysis to be prepared either by the chief financial officer (“CFO”), or by the treasury manager, or by their respective teams. In larger companies, this task normally corresponds to the treasury team, which is in charge of analyzing short-term cash movements in more detail, as well as any forecast of payments and collections.

In smaller companies, where there is no treasury team or department, this exercise is usually carried out by the CFO himself and his finance team.

What are the sources of information to build a liquidity model?

As we said initially, the liquidity model is a more detailed model. It is not valid for this analysis to start from long-term hypotheses that have not been contrasted or confirmed. The objective of the liquidity model is to make a much more exhaustive analysis and with real information available in the short term. Where does this information come from? Generally, real information is used, that is, it is the primary task of the person in charge of the liquidity model to reach the appropriate people in each department to access the real and most detailed information possible. For example, it is not worth going to the budget and obtaining the expected monthly sales. But it will be necessary to go to the sales person or to the CRM to take the specific sales data of the last 2 or 3 months to be able to estimate the corresponding charges, if the charge is not anticipated. On the payment side, it will be necessary to analyze all the invoices received from suppliers and see which have already been paid, which are going to be paid, which are pending payment, and thus be able to accurately estimate the payments for the next two or three months. In addition, a detailed review of future payments will have to be made beyond the invoices received. It will be necessary to analyze periods of payment of taxes, social security, and it will even be necessary to review with the different teams to see if there has been any extraordinary payment to be able to include it in the analysis. Imagine that the legal team requested an extraordinary service to make a report on the B2B payment market in Europe, and this cost ten thousand Euros to be paid in two months. If we do not do this exercise, it is possible that we will leave ten thousand euros on the table to pay that could conflict with some other payment if we have not made an adequate cash forecast. In addition, it is important to review debt maturities and interest payments, in the event that the company has short or long-term debt with third parties.

Structure of a liquidity model

In the previous section we commented how to create an adequate liquidity model it is necessary to be up to date with the latest information available. And for this it was necessary to go to the real sources of information, that is, real sales information, and real supplier invoices. However, this is not enough to create a good liquidity model. From Snab, we recommend using three sources of information to complete a good liquidity model.

As we said, first of all, the information on invoices issued and received is required, that is, the latest available and updated information. There is nothing more true and real than this information. Generally, this information serves to complete two or three months of information for the liquidity analysis. Second, we will use the annual budget or an updated variant or estimate thereof, if available. Normally, this information, since it is the second most real and detailed piece of information available after the invoices, will help us to complete the analysis from month four onwards, normally up to month twelve, that is, until the period that covered by the company’s annual budget. Third, it is very good practice to use the short-term financial model of the company to complete the remaining period that we want to analyze. The financial model should be the third most appropriate source of information within the company, so it can serve us adequately to complete those months for which we do not have more short-term information.

In conclusion, a liquidity model is made up of three sources of information, those mentioned above, which if connected correctly, give us a clear and very real image of the state of the company’s treasury. Uniting these three sources of information is not easy, which is why it is important to have an advanced knowledge of Excel in order to correctly connect the different sources of information.

Scenario analysis

To complete the liquidity model, it is usually advisable to finish with an analysis of scenarios or sensitivities. This makes it possible to test the robustness of the company’s cash position in the short term in different scenarios. These scenarios may reflect more macroeconomic hypotheses, or particular situations of the company. It is a rather discretionary analysis. In addition, this analysis of scenarios or sensitivities can be directed to different parts of the company structure. That is, variables such as price or sales volume can be sensitized. This would therefore affect the income side more. But, on the other hand, variables can be sensitized on the cost side. In other words, what happens if the cost of my suppliers grows, or if my company’s cost of electricity grows due to the current context, what happens if by agreement the company has to raise wages by a certain percentage. All these variables are variables that could be sensitized in this scenario analysis on the cost side. Finally, in the event that the company has bank debt, an additional analysis that would be appropriate to prepare, especially in this context of interest rate rises, is an analysis of the impact of the increase in the cost of debt. In this way, we can prepare the company in advance for a rise in interest costs.

Snab as a short-term cash forecasting tool

Snab is a pioneering treasury cloud platform in Europe and aims to provide finance staff with an additional tool to automate functions and tasks related to cash management and treasury management. Snab provides real-time visibility of the company’s cash, as well as upcoming payments and collections. Therefore, providing that short-term visibility of two or three months of real information that we mentioned earlier. The ideal would be to complete this real information on invoices issued and received with more long-term information. Snab, through information on past movements, also helps to anticipate the future by completing that part of the treasury forecast. Additionally, Snab serves as a banking aggregation platform, allowing finance teams to access all their bank accounts at different banks and in different countries from a single location in the cloud, without the need to access multiple banks individually. Snab also serves as a billing or accounts payable tool, that is, Snab automates the receipt of invoices, their scanning, and the automatic registration of their information. As we said, Snab is a payment and collection management tool, providing total control and visibility to the accounts payable and receivable functions, since the platform has innovative technology that allows you to pay and collect invoices in one click, without need to leave the platform. Finally, Snab is synchronized with the main ERPs in the market, which makes it possible to end the disconnection that exists in today’s world between different systems such as banking platforms and ERPs.