The importance of Liquidity in business is unarguable. Liquidity is a touchstone of your company’s ability to pay its bills and debts — showing how quickly you can do this using the assets you have and whether you can do it at all, without having to sell your own house at the beach or go bankrupt. An accountant would say it is your company’s ability to settle its current liabilities using cash or any other current assets it has.
Taking the term to a level down, assets also have their liquidity, defining how quickly they can be converted into cash (which is the most liquid of all the assets).
When you wait for too many payments from your customers and do not have enough money to pay your bills and taxes, you can become at a high liquidity risk. Keep your online bookkeeping neat and turn to your experienced accountant to help you estimate how close you might be to that risk.
What are current assets and current liabilities?
To estimate your company’s liquidity, you should first know what your current assets and current liabilities are. And it is the liquidity of the asset/liability that defines whether it is current or not.
To be current, an asset should be one that can be converted into cash within a year or less. Current assets include:
- Cash and its equivalents (for example, short-term stocks/bonds);
- Accounts receivable (money you have not received from the customers yet);
- Short term-investments;
- Prepaid expenses (For example, advertising contracts or insurance).
Speaking of the liquidity of the assets, cash is considered the most liquid, while land, real estate and buildings take the place of the least liquid among the assets, as it can take months to sell them. The assets are usually put in the balance sheet in order of their liquidity.
Liabilities can also be current and non-current. Here, the due date your particular liability is to be paid off defines the group. Current liabilities are those due to be paid within a year. They include:
- Accounts payable (money that you owe suppliers for the products you got on credit);
- Salary (money you owe your employees for working hours that they have already completed);
- Loans that you must pay within a year;
- Taxes you owe to the authorities.
How to measure liquidity?
Liquidity is measured by several accounting ratios, called liquidity ratios. The ratios show the amount of a company’s liquid assets (cash or assets that can be converted quickly) and how it corresponds with the company’s debts and other obligations. There are three of them: the current ratio, the acid test ratio and the cash ratio.
The current ratio (aka working capital ratio) shows how many times your company can pay off its current liabilities using its current assets. The formula for it is to divide the current assets by the current liabilities.
It is generally accepted that a company with a current ratio of 1 and above is seen as healthy, and a ratio below 1 would mean a company might have trouble paying its liabilities and will run into more debt or go into liquidation.
However, there are exceptions. For example, it can just mean that your company manages to keep its inventory low, and it is seen as good as it can reduce certain costs. Below 1 current ratio could be a normal sign for some industries, as well, where it is okay to get the payment from the customers quickly and it takes a long time to pay the suppliers.
The type of the debts you have is also important — out-of-pocket expenses are not so much of a problem, while, for example, owing much to external suppliers can make your business fail.
Jane’s business “Jose’s dream” which is a Mexican restaurant makes the counting of its current asset ratio: £27,000 (current assets)/£39,000 (current liabilities) which equals 0,692307, say, 0,7. Though the figure is below one, this is okay for Jane, as it is usually considered a norm for her business sphere and competitors.
John’s shoe production company “Laces&Spaces” also counts its current ratio: £25,000 (current assets)/£45,000 which equals 0,625. John looks at his liabilities and understands and most of the money he owes is the taxes to HMRC and, what’s worse, his credits to customers are not likely to be paid off soon. Ouch, it looks like it is time John call the creditors.
The acid test ratio (or a quick ratio) takes the counting a level down, narrowing the liabilities taken into account. To be more specific, it is actually the same as the current ratio, but with inventory being left out of the counting. So, to count it, you sum up cash and cash equivalents like marketable securities and account receivable and divide it all by your total current liabilities. The analysis is the same, so let’s have a look at the counting example in more detail.
Say, a company has:
Cash — £25,000
Marketable securities — £10,000
Account receivable — £20,000
Inventory — £50,000
Total current assets — £105,000
Accounts payable — £30,000
Accrued expenses — £20,000
Long-term debt — £15,000
Total current liabilities — £65,000
Applying the formula:
£105,000 / £65,000 = 1,6
The analysis of how good it is is the same as for the current ratio. So, 1,6 is usually a good sign for your company’s financial health.
And the cash ratio speaks for itself — you count whether you can cover your current liabilities only by available cash equivalents and marketable securities. The higher it is, the better.
How to increase liquidity?
Fair question — how to become more liquid? Here are some of the ways.
Boost your sales. Pretty obvious, but not less true. More sales — more earnings — more cash.
Decrease the level of inventory. The unsold-not-so-liquid inventory can be turned into highly liquid cash. However, watch the boundaries, some inventory might be crucial for your business, you still want it to function properly!
Reduce overheads costs. Renting an office or buying office supplies. Try to negotiate better deals with the landlord, or find a new cheaper place. Think of how many pens you actually use (hey, we are a typing generation!). I guess you get the idea, and do not be afraid to be called Scrooge McDuck.
Collect invoices quicker. Cut the time the customer is to pay to you, revise the payment terms to be more exact and specific or introduce fees for late payments. Or try to turn to invoice factoring.
Sell your assets. Again, not indispensable. Review your assets — maybe you have a piece of equipment, like a printer, you have not used for a year and is not likely to used for another twelve months. Sell it! And say sorry to the employee who used to use it as a table for his coffee cup.
Revise your debts. Liquidity is about current liabilities. Talk to suppliers and try to turn your short-term debts into long-term. Liquidy raised!
Liquidity vs solvency
Both liquidity and solvency are about your company’s ability to pay off its debts. The difference lies in time — liquidity is about current debts, meaning short-term liabilities, while solvency is about all of the company’s debts, including long-term liabilities. In other words, solvency can be described as long-term liquidity.
A company can be highly liquid, but insolvent, and vice-versa.
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