Whether you’re a small business owner or work at a major conglomerate, staying on top of your financial obligations is essential to the continued health and growth of your business. Business liquidity (sometimes shortened simply to liquidity) refers to your company’s ability to pay your bills when they’re due, without the need to compromise operations, sell assets, or incur additional debt.
As a metric, business liquidity is one of the most important ways both investors and accounting professionals use to evaluate a company’s creditworthiness and overall financial strength. When you improve your liquidity, you’re ensuring your cash flow is sufficient to keep production churning and invest in innovation as well as paying your debts.
What is Business Liquidity and Why Does It Matter?
For accounting professionals, business liquidity is defined as a measure of how readily your business can settle its current liabilities with cash and other current assets (also called short term assets).
Current liabilities include:
- Bill payments
- Short-term loans
- Accounts payable
- Any short-term liability your business is required to repay within the next 12 months
On the other side of the coin, current assets include:
- Cash/Cash Equivalents: Cash and any short-term securities that can quickly be sold for cash (e.g., short-term government bonds, money market funds, etc.)
- Accounts Receivable (AR): Money owed to you by your customers for the goods and services they’ve purchased. AR is considered liquid because they are generally collectable within a short period (a few weeks or months at most).
- Marketable Securities: Treasury bills, common stock, and any other publicly-sold, short-term securities that mature in 12 months (or less) and can be sold within three months.
- Inventory: Raw materials, unfinished goods, and unsold finished goods. Technically liquid, but the most difficult to convert to cash.
Calculating and managing business liquidity helps you reduce liquidity risk, i.e., the likelihood your company can’t cover its short-term liabilities. Businesses with high liquidity risk usually have poor cash flow management, an inordinate dependence on infusions of capital in the form of loans, or too much working capital tied up in inventory.
If liquidity risk gets too high, your business might succumb to insolvency—a complete inability to pay any of its debts. Insolvency can lead to costly restructuring or a fire-sale on valuable assets. In extreme cases, it can cause a business to declare bankruptcy, or even close its doors for good.
While the liquidity of a business is always important, it takes on even greater importance when the going gets tough. As far too many businesses have learned during the COVID-19 pandemic, cutting costs and optimizing cash flow to reduce liquidity risk is anything but optional when disaster strikes.
Note: Although often conflated with solvency, liquidity is distinct from it. Liquidity refers only to the ability to pay current debts, while solvency refers to a company’s ability to cover all of its financial obligations, both short- and long-term.
“If liquidity risk gets too high, your business might succumb to insolvency—a complete inability to pay any of its debts. Insolvency can lead to costly restructuring or a fire-sale on valuable assets. In extreme cases, it can cause a business to declare bankruptcy, or even close its doors for good.”
Calculating Your Company’s Liquidity
Like many other key performance indicators, the liquidity of a business can be expressed as a ratio. In fact, it can be expressed as one or more of three liquidity ratios:
- Current Ratio
- Acid Test Ratio
- Cash Ratio
1. Current Ratio
Also called the working capital ratio, this method uses entries from the balance sheet to determine the number of times a business can use its current assets to pay its current liabilities. It’s one of the easiest, and most popular, methods of ratio analysis for measuring the liquidity of a business.
You can calculate it with the following formula:
Current Assets ÷ Current Liabilities = Current Ratio
For example if your company has $40,000 in current assets and $27,000 in current liabilities:
40,000 ÷ 27,000 = 1.48
Ideally, your current ratio will always be 1 or greater, as values below 1 can indicate liquidity problems. If, for example, a company has excellent inventory management, however, their current ratio might dip below 1 even though they do have the assets available to cover their short-term liabilities. Current ratios below 1 are also common in the retail and restaurant trades, where payments are quickly collected from customers but suppliers are paid over longer periods of time.
2. Acid Test Ratio
This ratio (also known as the quick ratio) lets you hedge your bets a bit by leaving out inventory.
It’s calculated as follows:
(Cash Equivalents + Accounts Receivable + Marketable Securities) ÷ Current Liabilities = Acid Test Ratio
As with the current ratio, it’s important to contextualize the acid test ratio correctly. Removing inventory narrows your current assets to those that are most liquid, so if it falls below 1, it can indicate high liquidity risk. However, companies who are very adept at collecting accounts receivable in a timely fashion can have an acid test ratio of less than 1 and still be able to cover their current liabilities. Conversely, companies who struggle with actually collecting the accounts payable dollars listed on their balance sheet may find themselves with a score of greater than 1, but insufficient funds to pay the piper if pressed.
3. Cash Ratio
This is the most conservative of the liquidity ratios. It removes both inventory and AR, narrowing the calculation to its eponymous assets:
(Cash Equivalents + Marketable Securities) ÷ Current Liabilities = Cash Ratio
Companies with a high cash ratio can rest assured their liquidity is sufficient, as only the most liquid of current assets are included in the calculation.
Improving Your Company’s Liquidity
Once you know how to measure liquidity, the next step is improving it. Following a few basic best practices can help you reduce your liquidity risk and ensure you’ve got the cash flow you need.
1. Reduce Overhead.
Overhead expenses like rent, marketing, and other indirect expenses can take a deadly bite out of cash flow. The leaner your spend, the higher your profits, and the more liquidity you’ll preserve.
2. Eliminate Unproductive Assets.
If you’re holding onto assets that aren’t generating revenue—or, worse yet, are idle and consuming capital in the form of maintenance or storage—it’s time to let them go.
3. Leverage “Sweep Accounts.”
Your financial institution of choice should be able to help you set up sweep accounts, allowing you to transfer excess cash to interest-bearing accounts when they aren’t needed, and back to operating accounts when they are.
4. Keep a Tight Rein on Accounts Receivable.
The more effective you are at collecting timely payments from your own customers, the more flexibility you’ll have in paying your suppliers, investing in innovation, and funding growth.
5. Consider Refinancing if Necessary.
If you find yourself dealing with excess short-term liabilities and have a solid relationship with your creditors, you might consider consolidating some or all of your current liabilities into long-term debt you can pay down over time.
6. Maximize Productivity and Profits with Process Automation.
Perhaps the greatest overall contribution you can make to optimizing liquidity is an investment in technologies that not only increase efficiency and productivity, but continue to do so over time in order to make continuous improvement (along with greater value and savings) standard operating procedure. For example, a cloud-based, procure-to-pay (P2P) solution like PurchaseControl gives you:
- Immediate savings through automation of high-volume, repetitive tasks and elimination of human error.
- Improved cycle times and accuracy for purchase order and invoice processing.
- Faster processing means faster payments.
- More effective capture of early payment discounts where relevant.
- Improved overall vendor management.
- More effective contract management for negotiated discounts and optimal payment terms that extend the timeframe for payment where strategically useful.
- Better supplier relationship management through the elimination of late, duplicate, and incorrect payments.
- Additional savings, value, and cash flow through support for eInvoicing and automatic payments through workflow automation.
Optimize Liquidity to Keep Things Running Smoothly
Going with the flow can keep your company afloat in rough waters. Taking the time to optimize liquidity can give your company the healthy cash flow and flexibility it needs to thrive when times are good—and the savings and efficiency it needs when the going gets tough.
Streamline Business Processes, Improve Liquidity, and Generate Greater Value with PurchaseControlFind Out How