Businesses need cash to stay afloat. Even with healthy sales, if your company doesn’t havecash to operate, it will struggle to be successful. But looking at your company’s cashposition is more complicated than just glancing at your bank account.
Liquidity is a measure companies use to examine their ability to cover short-term financialobligations. It’s a measure of your business’s ability to convert assets—or anything yourcompany owns with financial value—into cash. Liquid assets can be quickly and easily changedinto currency. Healthy liquidity will help your company overcome financial challenges,secure loans and plan for your financial future.
What Is Liquidity in Accounting?
Liquidity is a measure of a company’s ability to pay off its short-term liabilities—thosethat will come due in less than a year. It’s usually shown as a ratio or a percentage ofwhat the company owes against what it owns. These measures can give you a glimpse into thefinancial health of the business.
For example, you might look at your current and upcoming bills and see that you have enoughcash on hand to cover all your expected expenses. Or you might see you need to tap otherinvestments and assets that can be converted to cash. The easier it is to convert the assetto cash, the more liquid the asset. For example, a store that sells collectable stamps mighthang onto its inventory to find just the right buyer to get the best price, which meansthose stamps are not very liquid. But if that same stamp store owns any stocks or bonds,those can be sold quickly, so those investments would be considered liquid.
Companies use assets to run their business, manufacture items or create value in other ways.Assets can include things like equipment or intellectual property. Inventory, or theproducts a company sells to generate revenue, is usually considered a current asset, becausegenerally it will be sold within a year. For an asset to be considered liquid, it needs tohave an established market with multiple interested buyers. Also, the asset must have theability to transfer ownership easily and quickly.
The information you’ll need to examine liquidity is found on your company’s balance sheet.Assets are listed in order of how quickly they can be turned into cash. So, at the top ofthe balance sheet is cash, the most liquid asset.
Also listed on the balance sheet are your liabilities, or what your company owes. Liabilitiesare listed in order of when they’ll come due. Bills your company will need to pay first arelisted at the top. Comparing the short-term obligations with the cash on hand and otherliquid assets helps you better understand the financial position of your business andcalculate insightful liquidity metrics and ratios.
Key Takeaways
- Liquidity refers to the company’s ability to pay off its short-term liabilities such asaccounts payable that come due in less than a year.
- Solvency refers to the organisation’s ability to pay its long-term liabilities.
- Banks and investors look at liquidity when deciding whether to loan or invest money in abusiness.
Liquidity Explained
Assets and investments your company owns have financial value. And liquidity indicates howquickly you can access that money, if you need to. Assets range in their liquidity. Forexample, you may have equity in a building your company owns. But that equity is not veryliquid because it would be difficult to convert it to cash to cover an unexpected and urgentexpense. On the other hand, inventory that you expect to sell in the near future would beconsidered a liquid asset. Though it’s still not as liquid as cash because although you mayexpect to sell your stock, unexpected circ*mstances might come up and stop that fromhappening.
Measuring liquidity can give you information for how your company is performing financiallyright now, as well as inform future financial planning. Liquidity planning is a coordinationof expected bills coming in and invoices you expect to send out through accounts receivableand accounts payable. The focus is finding times when you might fall short on the cash youneed to cover expected expenses and identifying ways to address those shortfalls. Withliquidity planning, you’ll also look for times when you might expect to have additional cashthat could be used for other investments or growth opportunities. To conduct liquidityplanning, you’ll perform the same current, quick and cash ratios we cover later in thisarticle for future scenarios to examine financial health.
Why Is Liquidity Important?
Here are a few of the benefits of taking stock of your liquidity on a regular basis:
Track the financial health of your business: You need to have enoughcash to meet financial obligations. But holding onto too much cash might leaveimportant investment and growth opportunities on the table. Measuring liquidityhelps you find the right balance, monitor the financial health of your company andpositioning it for strategic growth.
Secure a loan or other funding: Banks and investors look atliquidity ratios when determining a company’s ability to pay off debt.
Benchmark against other companies in your industry: Make and meetgoals by tracking what other similar and high performing companies in your industrydo.
What Are Assets?
Assets are resources that you use to run your business and generate revenue. They can betangible items like equipment used to create a product. Or assets can be intangible, like apatent or a financial security. Cash is also an asset. On a balance sheet, cash assets andcash equivalents, such as marketable securities, are listed along with inventory and otherphysical assets.
Liquidity of Assets
Assets are listed in order of how quickly they can be turned into cash—or how liquid theyare. Cash is listed first, followed by accounts receivableand inventory. These are all what is known as current assets. They are expected to be used,collected or sold within the year.
Noncurrent assets follow current assets on the balance sheet. Noncurrent assets include itemssuch as equipment and trademarks. These are assets that can’t be sold for cash quickly.
Most Liquid Assets
Current assets are the most liquid assets because they can be converted quickly into cash.They include cash equivalents, accounts receivable and inventory.
Least Liquid Assets
Noncurrent assets are the least liquid assets because it takes longer to sell them. Theyinclude equipment, buildings and trademarks.
Measuring Financial Liquidity
The concept of liquidity requires a company to compare the current assets of the business tothe current liabilities of the business. To evaluate a company’s liquidity position, financeleaders can calculate ratios from information found on the balance sheet.
What Is a Liquidity Ratio?
Liquidity ratios are a valuable way to see if your company’s assets will be able to cover itsliabilities when they come due. There are three common liquidity ratios.
Let’s calculate these ratios with the fictional company Escape Klaws, which sells thosedelightfully frustrating machines that grab stuffed animals.
Assets
Cash and cash equivalents =$1,000
Accounts receivable = $500
Inventory = $500
Total assets = $1,000 + $500 + $500= $2,000
Liabilities
Accounts payable = $500
Accrued expenses = $500
Inventory = $500
Total short-term liabilities = $500 +$500 = $1,000
The company also has long-term debt and shareholder equity of $1,000. But those won’t be usedin the liquidity ratios because they won’t come due in less than a year.
Current ratio. This indicates the company’s ability to repay business debtwith cash and cash-equivalent assets, i.e., inventory, accounts receivable and marketablesecurities. A higher ratio indicates the business is more capable of paying off itsshort-term debts. These ratios will differ according to the industry, but in general between1.5 to 2.5 is acceptable liquidity and good management of working capital. This means thatthe company has, for instance, $1.50 for every $1 in current liabilities. Lower ratios couldindicate liquidity problems, while higher ones could signal there may be too much workingcapital tied up in inventory.
Current ratio = current assets / currentliabilities
Escape Klaw’s current ratio
$2,000/$1,000 = 2
That means the business has $2 for every $1 in liabilities.
Acid test ratio/quick ratio. This ratio is more conservative and eliminatesthe current asset that is the hardest to turn into cash. In this case, we’ll eliminate the$500 in inventory (one machine). A ratio less than 1 might indicate difficulties in coveringshort-term debt.
Acid test ratio = current assets –inventory / current liabilities
Escape Klaw’s acid test ratio
$2,000 -$500 / $1,000 = 1.5
Cash ratio. This shows the company’s capacity to pay off short-term debtwith cash and cash equivalents, the most liquid assets. A ratio of at least .5 shows healthycash flow.
Cash ratio = cash andcash equivalents / current liabilities
Escape Klaw’s cash ratio
$1,000 /$1,000 = 1
Using and Interpreting Ratios
Intuitively it makes sense that a company is financially stronger when it’s able makepayroll, pay rent and cover expenses for products. But with complex spreadsheets and manymoving pieces, it can be difficult to see the financial health of your company at a glance.
Financial ratios are a way to look at your liquidity and measure the strength of your companyat a glance using different scenarios, such as covering liabilities with cash and cashequivalents, accounts receivable and even if you had to sell, or liquidate, some of yourinventory and equipment. These ratios are also a way to benchmark against other companies inyour industry and set goals to maintain or reach financial objectives.
In the example above, Escape Klaws could see quickly that it’s in a good position to pay offits short-term debts. The owner would still want to check in regularly and review thefinancial ratios to make sure changing market forces don’t disrupt its financial position.
Liquidity Examples
For an asset to be liquid, it must have a market with multiple possible buyers and be able totransfer ownership quickly. Equities are some of the most liquid assets because they usuallymeet both these qualifications. But not all equities trade at the same rates or attract thesame amount of interest from traders. A higher daily volume of trading indicates more buyersand a more liquid stock. Consider a diversity of investments to make capital available whenneeded.
Balance Sheet Example
A balance sheet is a way to look at how much your company owns and how much it owes at agiven point in time. This is where you’ll find the information you need to create yourliquidity ratios, which help make this information more digestible, easier to track andeasier to benchmark against peer companies.
| ASSETS | |
|---|---|
| Current assets | |
| Cash and cash equivalents | $16,000 |
| Accounts receivable | $2,000 |
| Inventory | $5,000 |
| Prepaid expenses | $1,000 |
| Total current assets | $24,000 |
| Non-current assets | |
| Equipment | $5,000 |
| Buildings | $150,000 |
| Vehicle | $5,000 |
| Total non-current assets | $160,000 |
| TOTAL ASSETS | $184,000 |
| LIABILITIES | |
| Current liabilities | |
| Accounts payable | $15,000 |
| Accrued expenses | $2,000 |
| Deferred revenue | $1,000 |
| Total current liabilities | $18,000 |
| Long-term debt | $150,000 |
| TOTAL LIABILITIES | $168,000 |
Using this example, we can calculate the three liquidity ratios to see the financial help ofthe company.
Current ratio = current assets / currentliabilities
$24,000 / $18,000 = 1.33
This means the company has $1.33 for every $1 in liabilities.
Acid test ratio = current assets –inventory / current liabilities
$24,000 – $5,000 / $18,000 = 1.1
A ratio of 1 or more indicates enough cash to cover current liabilities.
Cash ratio = cash and cash equivalents /current liabilities
$16,000 / $18,000 = .89
A ratio above .5 is usually a good indicator of a healthy cash flow.
What Is Liquidity Risk?
CPA Australia defines liquidity risk as the risk that a business willhave insufficient funds to meet its current and future financial commitments in a timelymanner, without materially affecting its daily operations or overall financial condition.Monitoring these financial ratios allows you to better gauge any liquidity risk, makeadjustments or take action.
Liquidity vs. Solvency
Liquidity is a measure of your company’s ability to meet short-term financial obligationsthat come due in less than a year. Solvency is a measure of its ability to meet long-termobligations, such as bank loans, pensions and credit lines. Liquidity is measured throughcurrent, quick and cash ratios. Solvency is examined through other ratios, including:
- Debt to assets ratio: How much of your company’s assets were financed through debt?
- Interest coverage ratio: Can your company pay the interest expense on its debt?
- Debt to equity ratio: How much of your company’s operations is financed with debt?
Short-term liquidity issues can lead to long-term solvency issues down the road. It’simportant to keep an eye on both, and financial ratios are a good way to track liquidity andsolvency risk.
How Can Liquidity Be Improved?
Finding more and new ways to hold onto and generate cash is a constant search for mostbusinesses. Think about ways to cut costs, such as paying invoices on time to avoid latefees, holding off on making capital expenditures and working with suppliers to find the mostcost-efficient payment terms. Try using long-term financing instead of short-term to improveyour liquidity ratio and free up cash to invest back in your business or pay offliabilities.
10 Ways to Boost Liquidity
Some of the best ways to boost liquidity include:
Increase sales: It may seem obvious, but more sales will mean morecash flow to your business. Expanding your sales force and new marketing initiativescan help drive sales. Employing different business models can also stoke sales — forexample, subscription or recurring revenue models, bundling or unbundling offerings.Examine your profit margins to inform your pricing. But keep in mind, cash may notcome in quickly enough to keep up with bills.
Reduce overhead: Overhead costs don’t directly drive revenue to yourbusiness. Some examples of overhead expenses are wages, rent, office supplies,insurance, and bank or legal fees. Closely examining your overhead can presentsurprising cost savings. For example, business situations change, and insurancepremiums might decrease as your company matures.
Improve invoice collection: NetSuite Brainyard offers some helpfultips for optimising accounts payable processes to ensure cash flow. These includeoffering discounts in return for quicker payments, sending reminders on unpaidinvoices, look to collect on customers with large payment balances and define weeklycash collection targets. Business accounting software can help you send accurateinvoices and track payment. And the accounts receivableturnover ratio can help you track progress.
Pay off debts faster: Liquidity ratios look at assets and debt thatwill come due in less than a year. Paying down debt will improve your liquidityratios. Don’t dip too far into cash savings to cover all debts, however. Be sure toanticipate expected and unplanned expenses.
Sell your assets: Are there assets your company has that aren’thelping drive revenue? These are known as unproductive assets and can often be soldto increase cash reserves. Examples include outdated or redundant equipment, unusedvehicles or property with no plans for development.
Refinance your debt: Move from short-term to long-term debt whereappropriate. This can lower interest rates and have smaller monthly payments givingyou more flexibility to meet short-term financial obligations.
Manage accounts payable: Efficient management of accountspayable can also boost your company’s liquidity. When they’re offered, takeadvantage of discounts for early payment, and negotiate longer payment terms withregular suppliers when they’re not. Don’t pay suppliers early when there’s nofinancial incentive to do so. And if necessary, prioritise payments to key suppliersto keep your business running.
Watch inventory: Don’t tie up cash in inventory. Closelymonitor the inventory to working capital ratio and achieve a balance that is in linewith the industry in which the business operates.
Examine and reduce operating costs: When facing a budget shortfall,common areas to cut expenses include business travel, office space, marketingbudgets and salaries and bonuses.
Prepare a cash flow projection: NetSuite Brainyard recommendslisting all future cash inflows and outflows in cash flowstatements by week or month and making sure to calculate ending cash balanceat the end of each week or month. This will help the business predict when cashbalances may dip below an acceptable level.
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Accounting software software helps acompany better determine its liquidity position by automating key functionality that helpssmooth cash inflow and outflow. NetSuite FinancialManagement automates more accounting processes and gives you and your finance teameasy access to data for analysis — with high impact functions to automate includinginvoicing, financial report generation, data collection and document storage, andcompliance.
The Reserve Bank of Australia's analysis of the financial stability of small businessesdemonstrates the importance of facilitating a smooth flow of funds in the economy to supportgrowth. By taking measures into account, such as liquidity, a business can make changes toensure it’s able to meet its debts, maximise the time it holds onto cash and ensure that ifit needs funding from a bank or investor it’s in the best possible position to get thatcapital.
