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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:
- Essential liquidity
The amount required to cover essential business operations such as wages, rent, mortgage, utility bills etc. - 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. - 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.
- Invoicing and income
Make sure you have a good handle on what’s coming in and when. It’s important to invoice on time and ensure people are paying on time so you don’t have an interruption in cash flow. You can make this easier with automated invoicing. - Look at your assets
Make a list of all assets within your business, their current value and how easy it would be to release the cash from each of them. This should be updated every few months as the business and market conditions change. It’s also good to know what steps would need to be taken to convert them to cash. - Prepare a financial forecast
If you start looking at your business projections and costing them out, you can identify any gaps in liquidity and any areas where you have excessive cash you might be able to invest. For example, if you plan to expand your premises, take on staff or buy better equipment. - Think about the three categories we identified above
Start to work out how much you need in each one should those needs arise. In some cases, this will be an educated guess but putting some cash in the pot for each one will still provide at least a partial buffer. - Asset allocation
Once you have a handle on how much you need and where it should go you can decide which assets you need to keep liquid and which ones you can afford to tie up. Some assets will definitely need to stay liquid to provide that cushion while others can potentially be used to create more investment opportunities or generate income elsewhere.
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:
- Reduce debt
If you have outstanding liabilities pay them off as quickly as you can as this can improve your liquidity ratio. - Avoid high-interest financing
A short-term loan may help plug a gap in your business but often comes with punishing interest rates. Pay it off if you can or look at ways to refinance at a cheaper rate. - Earn interest
Look for accounts which pay a decent rate of interest so if you have money that is sitting in the bank it will be working for you. - Stay on top of invoicing
This will aid greatly with cash flow. - Inventory management
Use inventory management software to stay on top of your stock control. You don’t want to tie up too much cash in stock but at the same time, you don’t want to run out of items either. - Reduce overheads
Utilities are increasingly expensive now so if your contracts are due for renewal shop around and see if you can get a better deal. Similarly, with insurance and rent, with some negotiation, you may be able to make savings.
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.
