A look at liquidity (2024)

Companies need money to stay afloat. Even with healthy sales, your business will struggle to succeed if it doesn't have the cash to operate. But looking at your company's liquidity is more complicated than just looking at your bank account. Liquidity is a measure that companies use to examine their ability to meet short-term financial obligations. It is a measure of your company's ability to convert assets (or anything your company owns with economic value) into cash. Liquid assets can be converted into currency quickly and easily. Healthy liquidity helps your business overcome financial challenges, secure loans and plan your financial future.

What is liquidity in accounting?

Liquidity is a measure of a company's ability to pay its short-term obligations, which are due within a year. It is usually stated as a ratio or percentage of what the company owes to what it owns. These measures can give you insight into the financial health of the company.

For example, you can look at your current and upcoming bills and see that you have enough cash on hand to cover all your expected expenses. Or you see that you need to tap into other investments and assets that can be converted into cash. The easier it is to convert the asset into cash, the more liquid the asset is. For example, a store that sells collectible stamps may hold on to its inventory to find just the right buyer to get the best price, meaning these stamps are not very liquid. However, if the same stamp shop owns stocks or bonds, they can be sold quickly, so these investments are considered liquid.

Companies use assets to run their business, produce goods, or create value in other ways. Assets can include things like equipment or intellectual property. Inventory, or the products a company sells to generate revenue, is typically considered a current asset because it will generally be sold within a year. For an asset to be considered liquid, it must have an established market with multiple interested buyers. The asset must also have the ability to transfer ownership easily and quickly.

The information you need to investigate liquidity can be found on your company's balance sheet. Assets are listed in order of how quickly they can be converted into cash. Cash, the most liquid asset, is at the top of the balance sheet.

The balance sheet also shows you what your debts are or what your company owes. The obligations are listed in order of when they expire. Bills that your business must pay first are listed at the top. By comparing current liabilities with cash and other liquid assets, you can better understand your company's financial position and calculate insightful liquidity metrics and ratios.

Key learning points

• Liquidity refers to the company's ability to pay its short-term obligations, such as accounts payable, that are due within a year.
• Solvency refers to the organization's ability to pay its long-term obligations.
• Banks and investors look at liquidity when deciding whether to lend money or invest in business.

Liquidity explained

Assets and investments that your company owns have economic value. And liquidity indicates how quickly you can access that money when you need it. Assets vary in their liquidity. For example, you may have shares in a building that your company owns. But that equity is not very liquid, as it would be difficult to convert it into cash to cover unexpected and urgent expenses. On the other hand, inventory that you expect to sell in the near future is considered a liquid asset. Although it is still not as liquid as cash, because even if you expect to sell your shares, unexpected circ*mstances may arise that prevent you from doing so.

Measuring liquidity can give you information about how your business is currently doing financially, as well as inform future financial planning. Liquidity planning is the coordination of the expected incoming invoices and the invoices you expect to send via debtors and creditors. The focus is on finding times when you may not have enough money to cover expected expenses and identifying ways to address these shortfalls. With liquidity planning, you also look for times when you can expect to have extra cash that can be used for other investments or growth opportunities. To perform liquidity planning, run the same current, quick, and cash ratios that we discuss later in this article for future scenarios to examine financial health.

Why is liquidity important?

Here are some benefits of taking stock of your cash flow regularly:

• Track your company's financial health:You must have enough cash to meet your financial obligations. But holding on to too much money can leave important investment and growth opportunities on the table. Measuring liquidity helps you find the right balance, monitor your company's financial health and position it for strategic growth.
• Arrange a loan or other financing:Banks and investors look at liquidity ratios to determine a company's ability to pay off its debt.
• Benchmark with other companies in your industry:Create and achieve goals by tracking what other similar and high-performing companies in your industry are doing.

What are assets?

Assets are resources you use to run your business and generate income. They can be tangible items, such as equipment used to make a product. Or assets can be intangible, such as a patent or financial security. Cash is also an asset. On a balance sheet, liquid assets and liquid assets, such as marketable securities, are listed along with inventories and other physical assets.

Liquidity of assets

Assets are listed in order of how quickly they can be converted into cash - or how liquid they are. Cash is shown first, followed byamounts still to be receivedand inventory. These are all so-called current assets. It is expected that they will be used, collected or sold within a year.

Fixed assets follow current assets on the balance sheet. Fixed assets include items such as equipment and trademarks. These are assets that cannot be quickly sold for cash.

Most liquid assets

Current assets are the most liquid assets because they can be quickly converted into cash. This includes cash, accounts receivable and inventory.

Minimum liquid assets

Fixed assets are the least liquid assets because they take longer to sell. This includes equipment, buildings and trademarks.

Measurement of financial liquidity

The concept of liquidity requires a company to compare the company's current assets with the company's current liabilities. To evaluate a company's liquidity position, financial managers can calculate ratios based on information on the balance sheet.

What is a liquidity ratio?

Liquidity ratios are a valuable way to see whether your company's assets will be able to cover its liabilities when they come due. There are three common liquidity ratios.

Let's calculate these ratios using the fictional company Escape Klaws, which sells the wonderfully frustrating plush-grabbing machines.

Activate

Obligations

The company also has long-term debt and equity of $1,000. But they will not be used under liquidity conditions because they do not expire within a year.

Current relationship.This indicates the company's ability to repay business debts with cash and liquid assets, i.e. inventories, receivables and marketable securities. A higher ratio indicates that the company is better able to pay off its short-term debt. These ratios vary depending on the industry, but generally between 1.5 and 2.5 represents acceptable liquidity and good working capital management. This means, for example, that the company has $1.50 for every $1 in current liabilities. Lower ratios can indicate liquidity problems, while higher ratios can indicate that there may be too much working capital in inventory.

This means the company has $2 for every $1 in liabilities.

Acid Test Ratio/Fast Ratio.This ratio is more conservative and eliminates the current assets that are most difficult to convert into cash. In this case, we remove the $500 worth of inventory (one machine). A ratio less than 1 may indicate difficulty in covering short-term debt.

Cash-ratio.This shows the company's ability to pay off short-term debt with cash and cash equivalents, the most liquid assets. A ratio of at least 0.5 indicates a healthy cash flow.

Use and interpretation of relationships

Intuitively, it makes sense that a company is financially stronger if it is able to pay wages and rent and cover the costs of products. But with complex spreadsheets and many moving parts, it can be difficult to see the financial health of your business at a glance.

Ratios are a way to look at your liquidity and measure the strength of your business at a glance using different scenarios, such as hedging liabilities with cash and cash equivalents, receivables, and even if you were to sell some of your inventory and equipment sell or liquidate. These ratios are also a way to benchmark against other companies in your industry and set goals to maintain or achieve financial goals.

In the example above, Escape Klaws was able to quickly see that it is in a good position to pay off short-term debt. The owner will still want to check in regularly and review financial ratios to ensure that changing market forces are not disrupting his financial position.

Examples of liquidity

For an asset to be liquid, it must have a market with multiple potential buyers and the ability to transfer ownership quickly. Stocks are among the most liquid assets because they typically meet both qualifications. But not all stocks trade at the same price or attract equal interest from traders. A higher daily trading volume indicates more buyers and a more liquid inventory. Consider a variety of investments to make capital available when needed.

Example of a balance sheet

A balance sheet is a way to see how much your business owns and how much it owes at any given time. Here you'll find the information you need to create your liquidity ratios, making that information more digestible, easier to track, and easier to benchmark against industry peers.

With this example, we can calculate the three liquidity ratios to see the financial support of the company.

That means the company has $1.33 for every $1 in liabilities.

A ratio of 1 or more indicates that there is sufficient cash to cover current liabilities.

A ratio above 0.5 is usually a good indicator of healthy cash flow.

What is liquidity risk?

OfFederal Reserve Bank of San Franciscodefines funding liquidity risk as the risk that a company will be unable to meet its current and future cash flow and collateral needs, both expected and unexpected, without significantly affecting its daily operations or overall financial condition. By monitoring these financial conditions, you can better assess any liquidity risks and make adjustments or trade.

Liquidity versus Solvency

Liquidity is a measure of your company's ability to meet short-term financial obligations that are due within a year. Solvency is a measure of the company's ability to meet long-term obligations, such as bank loans, pensions and lines of credit. Liquidity is measured using current, quick and liquid ratios. Solvency is examined based on other key figures, including:

• Debt to Assets: How much of your company's assets are financed by debt?
• Interest Coverage Ratio: Can your company pay the interest charges on its debt?
• Debt vs. Equity: How much of your company's operations are financed by debt?

Short-term liquidity problems can eventually lead to long-term solvency problems. It's important to keep an eye on both, and financial ratios are a good way to keep an eye on liquidity and solvency risk.

How can liquidity be improved?

Finding more and new ways to retain and generate money is a constant search for most companies. Think about itways to reduce costs, such as paying invoices on time to avoid late fees, waiting to make capital expenditures, and working with suppliers to find the most cost-effective payment terms. Try using long-term financing instead of short-term financing to improve your cash flow and free up money to invest back into your business or pay down debt.

11 Ways to Increase Liquidity

Some of the best ways to increase liquidity include:

1. Increase sales:It may seem obvious, but more sales means more cash flow for your business. Expanding your sales team and new marketing initiatives can help boost sales. Using different business models can also drive sales, for example subscription or recurring revenue models, bundling or unbundling of offers. Examine your profit margins to determine your prices. But keep in mind that the money may not come in fast enough to keep up with the bills.
2. Reduceer-overhead:Overhead costs do not directly generate revenue for your business. Some examples of fixed costs are wages, rent, office supplies, insurance and banking or legal costs. A close examination of your overhead costs can yield surprising cost savings. For example, business situations change and insurance premiums may decrease as your business matures.
3. Improve bill collection:The NetSuite Brainyard offers some useful tips for optimizing accounts payable processes to ensure cash flow. These include offering discounts in exchange for faster payments, sending reminders for unpaid invoices, collecting from customers with large payment balances, and defining weekly cash collection targets. Business accounting software allows you to send accurate invoices and track payments. Andaccounts receivable turnover ratiocan help you track progress.
4. Pay off your debt faster:Liquidity ratios look at assets and liabilities that mature within a year. Paying off debt improves your cash flow. However, don't dip too far into cash to cover all debts. Make sure you anticipate expected and unplanned expenses.
5. Sell ​​your belongings:Are there assets in your business that are not contributing to revenue generation? These are known as non-productive assets and can often be sold to increase cash reserves. Examples include outdated or redundant equipment, unused vehicles or properties without development plans.
6. Refinance your debt:Move from short-term debt to long-term debt if necessary. This can lower interest rates and provide smaller monthly payments, giving you more flexibility to meet your short-term financial obligations.
7. Manage creditors:Effective management ofcreditorscan also increase the liquidity of your business. If they are offered, take advantage of early payment discounts and negotiate longer payment terms with regular suppliers if not. Do not pay suppliers early if there is no financial incentive to do so. And, if necessary, prioritize payments to key suppliers to keep your business running.
8. View stock:Do not tie up cash in inventory. Closely monitor the inventory to working capital ratio and ensure a balance sheet is appropriate for the industry in which the company operates.
9. Research and reduce operating costs:If there is a budget deficit, common areas to cut include business travel, office space, marketing budgets, and salaries and bonuses.
10. Take advantage of PPP loan forgiveness:OfAmerican Small Business Administrationrecently announced that it would forgive about 70% of PPP loans – including all loans of $50,000 or less and even for sole proprietors.
11. Prepare a cash flow projection:NetSuite Brainyard recommends a list of all future cash inflows and outflowscash flow statementsper week or month and be sure to calculate the closing balance at the end of each week or month. This will help the company predict when the cash balance will fall below an acceptable level.

How can accounting software help?

Accounting softwarehelps a company better determine its liquidity position by automating key functionality that facilitates the inflow and outflow of cash.NetSuite Financial Managementautomates multiple accounting processes and gives you and your finance team easy access to data for analysis – with powerful automation features including invoicing, financial report generation, data collection and document storage, and compliance.

The Federal Reserve Bank of Chicago's analysis of financial health indicators for small businesses found that caution should be exercised in placing too much weight on revenue growth as an indicator of financial health. By taking other measures into account, such as liquidity, a company can make changes to ensure it is able to pay off its debt, maximize the time it has to liquidate and ensure that if is necessary for financing by a bank or investor, it is in order. the best possible position to obtain that capital. .