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What is liquidity? It is the ease and speed with which any asset can be converted into cash without reducing its price – in simpler terms, selling it for a good price. What is the most liquid asset? Cash, of course, as it doesn’t need to be converted to be immediately used for covering any expenses. But what about your business? What is its liquidity? How can it be influenced? Let’s discuss it in this article.
Recommend that you also read our article – How to Conduct a SWOT Analysis: Examples and Templates.
What is Business Liquidity?
By definition, liquidity is a company’s ability to meet current obligations or immediate and short-term liabilities using its current assets. Complicated? In simpler terms, a business’s liquidity is its ability to quickly sell all its assets and get money to pay off current obligations. It can be assessed by the ratio of available assets that can easily be converted to cash to the current cash needs.
When can we say that a business’s liquidity is low? When cash inflows do not cover expenses, and there are no assets that can be quickly sold to cover them. Does this necessarily mean the business is poor, with empty warehouses and no money? Not at all. You can have warehouses full of goods and lots of equipment, but if you can’t sell them quickly – liquidity is low. Moreover, large stocks that can’t be quickly sold due to their size are one of the reasons for low liquidity.
Measuring Business Liquidity
So, liquidity is not about the presence of material values but about their turnover. A very small business can be highly liquid if it is well-organized. There are four most common ratios for measuring liquidity in business:
- Current Ratio: It shows a business’s ability to pay short-term obligations. It is calculated as the ratio of all current assets to current liabilities. The higher it is, the more capable the business is of paying its debts. If it is below 2, this is a reason for concern and looking for ways to solve the problem.
- Quick Ratio: It is calculated as the ratio of liquid assets to short-term liabilities. It shows how well the business can pay current obligations without additional financing or selling stocks.
- Cash Ratio: For calculation, we take only cash and cash equivalents and find their ratio to current liabilities. This ratio shows how well the business can pay its obligations immediately, without looking for additional funds or selling assets.
- Inventory Turnover Ratio: It helps determine not just liquidity but also business efficiency. To determine it, you need to divide the cost of goods sold over a certain period by the value of the inventory. It shows how efficiently the company uses its assets. Perhaps, it is worth changing something in inventory management.
3 Liquidity Ratios – Video
Want to learn more about three liquidity ratios? Watch the Youtube video:
How to Improve Business Liquidity
How to achieve high liquidity ratios and improve your business efficiency? There are many ways, let’s start with the most obvious ones. In three out of four cases, we calculate the liquidity ratio as the ratio of assets to expenses. Therefore, it is logical to reduce expenses. You can also increase the liquidity of assets to make them easier to sell. You can change something in the organization of the business. Let’s see how.
Improve Liquidity by Reducing Overhead Costs
If your expenses significantly exceed your income – this definitely lowers liquidity. Eliminate expenses completely? Unfortunately, that’s unrealistic. But there are several ways to reduce them. You can try to reduce rent through negotiations or by finding another location, save on utilities and transportation. Sometimes simple things can significantly cut costs – switching to electronic document management, outsourcing some tasks. Think outside the box, turn off the coffee machine that consumes electricity and distracts employees.
Optimize Assets to Improve Liquidity
Huge stockpiles in warehouses are not only a protection against future shortages but also a serious problem that lowers liquidity. If so much money is spent on stock purchases that there is not enough to pay current bills and you can’t sell it quickly, it becomes a burden. The same goes for excess equipment. It’s great to have everything on hand, but if it is used once a year, it is better to rent it when needed. Selling or renting out excess equipment can free up space and money.
Use Different Financial Tactics to Improve Liquidity
Sometimes our mistakes cost us a successful business. It’s not always worth buying equipment; sometimes it’s better to rent it. Occasionally, it’s better to take a long-term loan to reduce monthly payments. Even if in the long term you have to pay more, in the short term, it significantly increases liquidity. Don’t be afraid of unconventional solutions.
Conclusions
Liquidity is a business’s ability to pay current obligations using its available assets. To improve it, it is worth planning work properly, avoiding excessive current expenses and large stocks, and striving to maintain an intense turnover of goods.
Frequently Asked Questions about Business Liquidity
In short, liquidity is the ability of a company to generate cash to meet obligations.
Cash flows decrease, there is no money to cover current expenses despite having large stocks, etc.
Low liquidity leads to cash shortages, limits growth opportunities, and makes the company more vulnerable to economic downturns.
Steve Davey is the chief editor and author of the English-language section at our portal. With a keen eye for compelling topics in American media, Steve not only shares his insights but also occasionally translates them for our audience. His expertise in uncovering engaging stories and his editorial skills contribute significantly to the richness of our content.