Business liquidity refers to how quickly and easily a business can convert assets into cash, so a company with high liquidity will be able to rapidly raise money to meet unexpected costs without having to increase borrowing.
Business liquidity is determined by how quickly a business can convert its assets into cash. Non-cash assets in this context could include stock, equipment, and money owed by debtors, but individual businesses may hold different assets depending on their industry and business type.
So what causes the liquidity of a business to alter? Overtrading is just one example where business liquidity can change unfavourably. A business might take on a large contract, for example, but if there are insufficient resources it’s likely to eventually become overstretched.
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Why is business liquidity important?
If an enterprise cannot quickly generate cash from its assets when necessary, it can create serious problems if a sudden cash shortfall is experienced or an unexpected bill needs to be paid. In other words, the speed with which cash can be generated in the short-term can make a difference to its long-term functionality.
The importance of business liquidity is clear when you consider the impact of losing a significant proportion of income if a large customer moves away from the business. Bills still need to be paid and if the organisation can’t convert any of its assets into cash in time, it may become insolvent.
How business liquidity is measured
Ratios are used to measure a business’ liquidity, and the two most common liquidity ratios are the current ratio and the quick ratio.
The business’ current assets are divided by its current liabilities – ‘current’ in this case means they can be dealt with (converted into cash, or paid) within 12 months. A current ratio below 1.0 could be a cause for concern, but results should be compared with similar businesses to obtain a broader view. The current ratio is also known as the working capital ratio, and if it suddenly falls significantly it indicates the business could have liquidity/potential solvency issues.
Also known as the acid test ratio, the quick ratio is calculated as above but without the inclusion of stock in the calculation. This is because inventory can be difficult to convert into cash quickly without losing value.
There are also industry variables - some industries such as construction might not include debtors in the calculation, for example, as it takes longer to collect debts in that industry than in others.
Again, a quick ratio of less than 1.0 should cause alarm, but as with the current ratio consideration should be given to the industry in which the business operates as well as industry trends.
Hard assets such as property are among the most liquidity of business assets, which means they can’t be converted into cash quickly or it’s not possible to do so without a significant loss in value.
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How to manage business liquidity
Being aware of where money is spent, and projecting future spending, is important when managing business liquidity. Cash flow forecasts provide valuable information that provides a ‘high level’ view of a business’ cash needs over the coming months. They can be used to control liquidity, and avoid having to seek emergency additional finance to prevent further distress.
Our experts at Real Business Rescue can provide reliable independent advice on the liquidity of your business, and offer professional guidance if you’re at risk of financial decline. We have extensive experience in all industries and understand the inherent issues that can affect liquidity.