Most business owners are great at assessing the profitability of their business by ensuring sales are strong and money is coming in. Something that is less obvious or known to business owners is the assessment and monitoring of liquidity. In simple words, liquidity is a business’s ability to repay its short-term obligations using its short-term assets. Companies with poor liquidity can experience cash flow problems which can result in further operational problems. For this reason, it’s important to understand what liquidity is and how you can measure it, let’s explore these concepts below.
Business Liquidity Explained?
Business liquidity is a company’s ability to cover short-term financial obligations using short-term assets. Typically, when a business has good liquidity, it means that the company can sell their current assets for cash and use that cash to repay short-term financial obligations, also known as current liabilities, in under a year. Business liquidity is the most accurate way to measure a company’s financial health.
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How To Measure Business Liquidity
In the world of accounting, liquidity is a measure of how easily an asset can be turned to cash, with cash being the benchmark. Of course, cash is the most liquid asset that exists because it can be used to repay any debt.
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Another important factor of liquidity is being able to convert the asset into cash without losing significant value. In addition, current assets should be convertible into cash within a year, otherwise, it is not considered to be particularly liquid. Stocks, accounts receivable, and bonds are assets that very liquid because they can be sold for their full value easily and quickly. Less liquid assets include land, equipment, and real estate because they are difficult to sell rapidly and getting the full value isn’t always possible.
On your company’s balance sheet, you might notice that assets and liabilities have a current and a long-term section. This is essentially the division of liquid assets and short-term liabilities from their long-term counterparts which is important for the measurement of liquidity. A company’s liquidity is normally expressed as a ratio. There are three major liquidity ratios that you can calculate easily, let’s explore them below.
Current Ratio (or Working Capital Ratio) = Current Assets / Current Liabilities
This is the most commonly used and easy to calculate ratio out of all the liquidity formulas. Because current assets and current liabilities are already broken down on your balance sheet, it doesn’t take much time to find the values you need. A ratio of 1 means that your current assets will cover your current liabilities exactly. You should aim for a ratio above 1 because the larger this ratio is, the more liquid and financially healthy your business is. Generally speaking, a ratio of 2:1 is the most ideal.
Quick Ratio (or Acid Test)= (Cash Equivalents + Marketable Securities + Accounts Receivable) / Current Liabilities
This ratio is very similar to the current ratio above, but it eliminates less liquid assets such as prepaid expenses and inventory. As with the current ratio, you’re aiming for a ratio of 1 or higher, with 2:1 being the most ideal.
Cash Ratio = (Cash + Cash Equivalents) / Current Liabilities
Out of all the liquidity ratios, this is the most strict and purest measurement of liquidity in a business. Having a ratio of 1 or higher is ideal and will prove that your business is extremely liquid. This is also the ratio that creditors and investors frequently use when determining a business’s financial health before making a decision.
How To Improve Your Business’ Liquidity
If you find that your business’ liquidity isn’t the greatest, don’t panic because there are ways to improve it. Let’s explore how you can increase your business’ liquidity below.
- Sell long-term assets that you rarely or no longer use
- Increase efforts to send invoices early and to obtain payment from clients on time
- Use invoice factoring for unpaid invoices
- Reduce expenses where possible
- Negotiate longer payment terms with vendors
- Take out a long-term loan
- Reduce the amount of money you take out of the business
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Why Does Liquidity Matter?
Liquidity is basically another way of determining your business’s accessible funds. As you probably already know, cash flow is quintessential for businesses, especially for small companies and startups (learn how to get a startup business loan). If your cash flow is ever suffering, it is good to know that you have current assets that can cover your current liabilities if you need it. Liquidity basically equates to peace of mind.
Many business owners who are just starting out might think that if their business is doing well, liquidity isn’t important. The reality is, making a sale doesn’t always do justice for your cash flow and liquidity due to timing. If you sell a product or service today, you might not get the cash in your hand for another month, maybe longer. This is why cash flow and liquidity should be considered in addition to profitability.
Regularly assessing your business’ liquidity will help catch problems before they start and help you make better decisions on a day to day basis. Even if a crisis happens, you’ll have comfort in the fact that your business is liquid and have the financial means to deal with the situation.
Another reason why liquidity is important is for financing and investment purposes. Creditors and investors will make decisions based on your financial statements. They’ll assess various parts of your financials, including liquidity. Having poor liquidity could cost you a loan or other forms of financing.
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Liquid Businesses Are Healthy Businesses
As we saw above, a liquid business is better able to handle a crisis, manage their cash flow and will perform well in the long run. Liquidity doesn’t take long to assess and can be fixed if it’s not the greatest. Start assessing your business’ liquidity today for a better financial future.
