Business Liquidity: What is Liquidity and How to Plan for it

Business Liquidity: What is Liquidity and How to Plan for it
Business liquidity is a measure of how quickly a business can convert its assets to cash to cover its liabilities. Learn how it affects your business and how to calculate it.
Dec 03, 2022 — 4 min read
Business Liquidity: What is Liquidity and How to Plan for it

Having a good grasp of business liquidity will help you make sure cash flow remains strong so you can cover any expenses and unexpected events.

What is business liquidity?

Business liquidity is your ability to cover any short-term liabilities such as loans, staff wages, bills and taxes. Strong liquidity means there’s enough cash to pay off any debts that may arise. If a business has low liquidity, however, it doesn’t have sufficient money or easily liquefiable assets to pay those debts and may have to take on further debt, such as a loan, to cover them.

All businesses will have assets which are highly liquid and ones which are not. Cash is the most liquid of all but other assets with high liquidity include shares or inventory provided you can sell it quickly. Assets with low liquidity include property or large, expensive equipment, which take longer to sell.

Why is liquidity important in a business?

Good liquidity puts your business in a strong position and will help you weather any unforeseen financial challenges. Poor liquidity, on the other hand, means a business is at higher risk of failing if suddenly faced with unexpected debt, for example, a costly machine repair or a large VAT bill. If the business is unable to convert enough assets to cash quickly to cover the debt it can push it into insolvency.

What are the pros and cons of liquidity?

The main advantage of strong liquidity is knowing there are enough assets to cover unexpected emergencies, changes in demand and surprise expenses. It can also improve a business’s credit score which will give you a greater chance of securing funding should you need it.

However, high liquidity has its drawbacks too. While it won’t hurt your business, keeping it too high could be preventing you from seizing opportunities to help your business grow such as investing in better equipment or employing an extra member of staff to increase productivity. Cash in the bank is reassuring but it could be working harder and supporting your business goals rather than just sitting there.

What is liquidity planning?

Business liquidity management or planning is a fine balance between ensuring there are sufficient liquid assets to cover any liabilities and not keeping so much back that it affects longer-term business growth plans. You can divide liquidity into three sub-categories when planning how much you need:

  1. Essential liquidity
    The amount required to cover essential business operations such as wages, rent, mortgage, utility bills etc.
  2. Precautionary liquidity
    This will be funds you can liquidate quickly and easily at a relatively low cost if you found yourself in a bind. For example, facing unexpected repair bills or legal fees.
  3. Discretionary liquidity
    This covers investment opportunities which are too good to pass up but tie up larger amounts of cash. However, you should still be able to access funds from these relatively quickly and cheaply should you need to.

How do I create a liquidity plan?

It’s a good idea to do a liquidity audit of your business and calculate how much you have available.

How can I improve my liquidity?

Planning will go some way to improving your liquid position but there are other things you can do to have an immediate effect:

How do I calculate liquidity?

There are three different ways you can calculate your liquidity – current ratio, cash ratio and quick ratio. It will depend on the type of business you run as to which one works best for you but typically a value of 1 or above indicates good liquidity. Below one indicates a high liquidity risk. A business with a liquidity ratio of two, for example, could effectively cover its debts twice over. A business with 0.5, meanwhile, only has enough to cover half its debts and could be at risk of failure if they are all due at the same time.

Current ratio

This is your total current assets divided by your total current liabilities. It is the simplest way to calculate liquidity.

Quick ratio

You calculate the quick ratio by dividing current assets minus inventory by current liabilities. Because inventory and prepaid expenses are omitted (because these are less liquid) it is a stricter test of liquidity.

Cash ratio

This test is stricter still because it only takes into account your most liquid assets. You calculate the cash ratio by dividing cash and cash equivalents by your current liabilities.

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