Liquidity has several definitions: there’s a broad understanding of what liquidity is and an accounting-specific meaning.
Liquidity in general terms means the amount of assets a person or company has that are either in cash form or can be easily sold for cash.
Accounting liquidity is a measure of how easily an individual or business can pay their bills using all the liquid assets they own, within a period of one year. That means comparing liquid assets to outstanding liabilities.
General liquidity simply measures what you might have that’s cash (or easily converted to cash), while accounting liquidity takes it one step further and applies those liquid assets to existing debts.
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How Can Business Owners Analyze Their Liquidity?
Curious about the differences between the balance sheet and income statement? Check out this blog:
Calculating liquidity ratios will help both internal business stakeholders and external parties (investors and loan officers) evaluate the liquidity of the business.
The current ratio determines liquidity by taking the business’s current assets and dividing them by its current liabilities.
The quick ratio, also referred to as the acid-test ratio, uses the same calculation (current assets / current liabilities) minus inventory.
The operating cash flow ratio demonstrates how well a company’s financial obligations can be met by cash brought in from its current operations. The calculation changes slightly, in that it is operating cash flow divided by current liabilities.
For all three liquidity ratios, a ratio larger than 1 is preferable as it’s an indicator of financial health. However, the average ratio per industry may be higher or lower, depending on what’s expected in terms of performance (for that industry).
Take Note: Liquidity and solvency are often confused. While they are similar concepts, they serve different purposes. Learn more about the differences between the two here.
Why Should Business Owners Care About Liquidity?
Liquidity is a key component of a healthy business with long-term potential. Here’s why:
Just Like Individuals, Businesses Need A Safety Net
Emergencies happen to businesses, too. You never know when it may be absolutely critical to make a large inventory purchase, upgrade a software system, or hire a large group of new employees.
Without a liquid asset base, small businesses have their hands tied behind their backs. What could be accomplished easily may now require a trip to the bank or a time-consuming round of funding. Staying liquid means that the assets you have can be quickly converted to meet a time-sensitive need.
Small Businesses Might Also Need Loans
When applying for loan or credit financing, having healthy liquidity ratios makes your business look good on paper. Investors and loan officers can see a demonstrated ability to fulfill financial obligations, and it makes it easier for them to say “yes” to your financing request.
With a lower ratio of assets to liabilities, outside parties may wonder if your business will be able to pay its bills – and decide to invest their money elsewhere.
Liquidity Ratios Can Guide A Business Owner’s Decision-Making Process
Liquidity is an important marker of a business’s financial health. Reviewing it and understanding why it is the way it is can help business owners decide what steps to take next.
If liquidity ratios are too high, it might be time to take some of that cash and reinvest it in the business. That could mean updated equipment, training for staff, or investments in marketing and sales strategies.
If liquidity ratios are too low, businesses can evaluate all the company’s assets to see what can (and should) be liquidated. And they can look at outstanding liabilities to determine if everything they’re paying for is a “must-have.” Maybe cutting some products or services can reduce the company’s financial obligations.
How Often Should Business Owners Review Liquidity?
When it comes to liquidity and the health of the business, it’s important to review it frequently so as not to miss out on opportunities for improvement. And what happens on the financial side of the business can change quickly – liquidity may go up or down at a fast pace.
We recommend reviewing liquidity ratios on a monthly basis, as business owners are reviewing their balance sheets. It’s often helpful to review your business solvency (a similar concept) at the same time.
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