Why is liquidity important for a business? To measure how quickly a business can convert its current assets into cash, we use the term ‘business liquidity’. Assets in this case could consist of stock, equipment or money owed from debtors. This article defines the financial health of the business
Nevertheless, depending on their industry and structure, different businesses possess dissimilar types of non-cash assets.
So what causes the liquidity of a business to alter?
An unfortunate consequence of taking on too much, such as a large contract, is that it can lead to an unfavourable shift in business liquidity. Your resources can become stretched beyond capacity if you do not carefully consider the amount of work or contracts that you are undertaking.
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Why is this important?
Having the power to swiftly generate cash from current assets is essential for any business. If a company experiences an unexpected bill or money shortage, not having access to quick cash can have dire results on its long-term survival. Thus, one’s ability to obtain liquidity quickly in times of necessity plays a crucial role in their continued success and growth.
It’s crucial to understand the importance to avoid being caught off guard if a substantial customer moves away from the company. Payments still need to be made, and without having access to liquid assets that can quickly turn into cash, liquidation may become unavoidable.
How business liquidity is measured
To assess the cash flow of a business, cash ratios are essential tools; two main liquidity ratios that provide this insight include the current ratio and the acid test ratio.
To calculate the company’s current assets, divide them by its current liabilities – which in this case refer to any debt that is expected to be paid or exchanged for cash within 12 months. A cash ratio lower than 1.0 could suggest a problem, but for a more accurate depiction, it should be compared with similar businesses with the same cash ratio. This number is also known as the working capital ratio; if it drops significantly all of a sudden, then there may be the company’s liquidity and solvency issues at hand with your financial obligations for unpaid invoices.
More commonly known as the acid test ratio, the quick ratio (acid test ratio) – cash equivalents is determined by omitting stock from its calculations. This is because it can be hard to promptly turn inventory into cash equivalents without losing value in the process.
Of the current assets considered highly liquid, cash ranks at the top of the list. Other kinds of assets, such as marketable securities, accounts receivable, inventory and prepaid expenses, are less liquid because they need to be sold to be converted into cash. A liquid asset is an asset that can easily be converted into cash within a short amount of time. Fixed or long-term assets are considered less liquid because converting them to cash can take months or even years.
Other liquidity considerations
Taking into consideration the industry, certain sectors, such as construction, for example, may not factor debtors into the computation since traditionally it requires a longer time to recover debts from them. If it’s difficult to sell the equipment at its market value due to a lack of demand, it can be considered a liquidity risk. Any business that risks not being able to meet its obligations because of its assets is experiencing liquidity risk. Businesses in mature industries often have a wealth of very liquid assets because they have a history of bringing in cash.
If liquidity ratio falls below 1.0, it is cause for concern and warrants further investigation. Despite this warning sign, caution should be applied when considering the current ratio as each business operates within its own industry with specific trends that must be accounted for. Hard assets such as property are notoriously difficult to convert into cash without significantly reducing their value; therefore, these types of investments tend to reduce liquidity levels across businesses even though they may have long-term benefits.
Cash is generally the most liquid asset because it’s available at the touch of a few buttons on an ATM pad or a digital app — or sometimes in your wallet.
The moment a company incurs debt, two equalizing transactions take place on its balance sheet: the company records a cash balance and a debt. This is called double-entry accounting. Because of this, using borrowed cash directly affects liquidity and your ability to pay.
How to manage business liquidity
Keeping track of your budget and finances is key to maintaining business liquidity. Cash flow forecasts give you the necessary insight into a high-level view of cash needs for upcoming months, giving you a better handle on financial wellness. This allows directors to control their funds without having to resort to emergency financing or risk future distress.
Our specialized team of experts at Company Doctor is here to provide you with dependable, independent advice and support regarding the liquidity of your business. With a long history in many different industries, we are familiar with all the potential complications that can affect liquidity. If the risk of financial decline looms on your horizon, we will assist you every step of the way with our professional guidance.
Taking the time to optimize liquidity can give your company the healthy cash flow and flexibility it needs to thrive when times are good—and the savings and efficiency it needs when the going gets tough.