Your company’s liquidity shows how well you can pay off your current debt using your current assets. Cash, accounts receivable, and investments you can turn into cash quickly all qualify as liquid assets. When you compare those liquid assets to your current debts, you want to strike a balance. Too much liquidity means you have more room for investment back into your business. Too little liquidity can leave you unable to handle your liabilities.
Keeping Up With Regular Expenses
You need enough cash to cover your regular expenses to keep your company running. That includes expenses such as paying your employees’ wages, ordering inventory, and paying monthly recurring bills like rent. When your liquidity is too low, you may struggle to keep up with those expenses. Having to take out short-term emergency loans impacts your personal credit score and increases the risk related to your company. Those loans usually come with higher interest rates, especially since your low liquidity may put you in the high-risk category. Maintaining good liquidity makes it easier to cover your regular expenses to keep you in a good financial position.
Funding for Emergencies
Having an emergency cash fund helps you keep your cool if you face any type of financial crunch. Maybe your main manufacturing equipment breaks down and you have to wait a week to get the right parts to fix it. That slows your production and affects your business. Or you might experience an unexpected decrease in sales that cuts into your cash. When you build up your liquidity, you have a safety net to keep up with your expenses, even if something out of your control causes a dip in revenue.
Getting Approved for Financing
Liquidity directly impacts your ability to get loans from investors. When you go to external parties for funding, they want to know you can pay off those loans, both in the short and long term. Lenders usually put more emphasis on your company’s overall solvency, but a financial institution may also analyze your liquidity before approving you for a loan. It may be easier to get approved for the amount of money you need when you have high liquidity. You may also get a better interest rate and have fewer restrictions placed on the loan if you have more liquidity. This can help you get the funding you need at rates that make them easier to pay off.
Tracking Your Financial Health
Being aware of your liquidity helps you keep tabs on your company’s financial health. You’re able to see how well you can keep up with your debt. Looking at liquidity also tells you how much of a financial cushion you have. Liquidity is something that can change frequently, so checking in on your liquidity regularly helps you stay on top of your financial situation.
Making Financial Decisions About Short-Term Liquidity
You can use your liquidity levels to help you make financial decisions. For example, if you notice your liquidity is high, you may decide to invest in improving your equipment, moving to a larger space, or expanding into new markets. If you have low liquidity, you may decide to sell some of your long-term assets to give your company more cash. Or if you’re already considering a business move, you might look at your liquidity level to help you decide if the move is a good one.
Utilizing Liquidity Ratios
Using an analysis process such as liquidity ratios helps you easily calculate your liquidity. These financial metrics convert balance sheet items into specific calculations that establish a relative level of liquidity. For example, just because a small business has $100,000 cash on hand doesn’t necessarily determine whether the company is liquid or whether the figure is sufficient, because all companies and industries are different. Liquidity ratios help scale operations and create comparable figures.
- The current ratio divides current assets by current liabilities. This measures your company’s ability to cover short-term debts with all short-term assets.
- The quick ratio compares only the most liquid assets – cash and accounts receivable – to current liabilities. This measures your company’s ability to pay current bills using only the assets easiest to convert.
- The working capital ratio subtracts current assets from current liabilities. This measures the cash flow available after current bills are paid.
You can use all three of these metrics to analyze and maintain the appropriate balance of current assets and current liabilities.
Why are Liquidity Ratios Important?
Investors look at these liquidity ratios to measure how well your company responds to additional debt load. That’s because when more investments come into play, your company owes more debt. Ideally, you would use the extra investment to bring in more cash to pay for short-term debts. However, the more cash you have on hand to pay for short-term liabilities, the better position you’re in to take on a higher debt load from investors.
Ideal Cash Reserve
Determining your ideal cash reserve is a balancing act. You want plenty of cash and other liquid assets on hand in case of emergencies. But having resources tied up in cash limits your ability to use the funds towards your business. Cash loses purchasing power in an inflationary market, so keeping too much on hand can decrease your purchasing power even though you still have the same amount of money in the bank.
Look at cash flow projections from the next 12 months to create forecasts. A startup should plan for higher liquidity in case of unexpected expenses. More established businesses can rely more on accounts receivable and inventory turnover, so this liquidity should be in easily convertible goods.
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