A Look at Liquidity (2024)

Businesses need cash to stay afloat. Even with healthy sales, if your company doesn’thavecash to operate, it will struggle to be successful. But looking at your company’s cashposition is more complicated than just glancing at your bank account. Liquidity is a measurecompanies uses to examine their ability to cover short-term financial obligations.It’s ameasure of your business’s ability to convert assets—or anything your companyowns withfinancial value—into cash. Liquid assets can be quickly and easily changed intocurrency.Healthy liquidity will help your company overcome financial challenges, secure loans andplan for your financial future.

What Is Liquidity in Accounting?

Liquidity is a measure of a company’s ability to pay off its short-termliabilities—thosethat will come due in less than a year. It’s usually shown as a ratio or a percentageofwhat the company owes against what it owns. These measures can give you a glimpse into thefinancial health of the business.

For example, you might look at your current and upcoming bills and see that you have enoughcash on hand to cover all your expected expenses. Or you might see you need to tap otherinvestments and assets that can be converted to cash. The easier it is to convert the assetto cash, the more liquid the asset. For example, a store that sells collectable stamps mighthang onto its inventory to find just the right buyer to get the best price, which meansthose stamps are not very liquid. But if that same stamp store owns any stocks or bonds,those can be sold quickly, so those investments would be considered liquid.

Companies use assets to run their business, manufacture items or create value in other ways.Assets can include things like equipment or intellectual property. Inventory, or theproducts a company sells to generate revenue, is usually considered a current asset, becausegenerally it will be sold within a year. For an asset to be considered liquid, it needs tohave an established market with multiple interested buyers. Also, the asset must have theability to transfer ownership easily and quickly.

The information you’ll need to examine liquidity is found on your company’sbalance sheet.Assets are listed in order of how quickly they can be turned into cash. So, at the top ofthe balance sheet is cash, the most liquid asset.

Also listed on the balance sheet are your liabilities, or what your company owes. Liabilitiesare listed in order of when they’ll come due. Bills your company will need to payfirst arelisted at the top. Comparing the short-term obligations with the cash on hand and otherliquid assets helps you better understand the financial position of your business andcalculate insightful liquidity metrics and ratios.

Key Takeaways

• Liquidity refers to the company’s ability to pay off its short-term liabilitiessuch asaccounts payable that come due in less than a year.
• Solvency refers to the organization’s ability to pay its long-term liabilities.
• Banks and investors look at liquidity when deciding whether to loan or invest money in abusiness.

Liquidity Explained

Assets and investments your company owns have financial value. And liquidity indicates howquickly you can access that money, if you need to. Assets range in their liquidity. Forexample, you may have equity in a building your company owns. But that equity is not veryliquid because it would be difficult to convert it to cash to cover an unexpected and urgentexpense. On the other hand, inventory that you expect to sell in the near future would beconsidered a liquid asset. Though it’s still not as liquid as cash because althoughyou mayexpect to sell your stock, unexpected circ*mstances might come up and stop that fromhappening.

Measuring liquidity can give you information for how your company is performing financiallyright now, as well as inform future financial planning. Liquidity planning is a coordinationof expected bills coming in and invoices you expect to send out through accounts receivableand accounts payable. The focus is finding times when you might fall short on the cash youneed to cover expected expenses and identifying ways to address those shortfalls. Withliquidity planning, you’ll also look for times when you might expect to haveadditional cashthat could be used for other investments or growth opportunities. To conduct liquidityplanning, you’ll perform the same current, quick and cash ratios we cover later inthisarticle for future scenarios to examine financial health.

Why Is Liquidity Important?

Here are a few of the benefits of taking stock of your liquidity on a regular basis:

• Track the financial health of your business: You need to have enoughcash to meet financial obligations. But holding onto too much cash might leave importantinvestment and growth opportunities on the table. Measuring liquidity helps you find theright balance, monitoring the financial health of your company and positioning it forstrategic growth.
• Secure a loan or other funding: Banks and investors look at liquidityratios in determining the company’s ability to pay off debt.
• Benchmark against other companies in your industry: Make and meet goalsby tracking what other similar and high performing companies in your industry do.

What are Assets?

Assets are resources that you use to run your business and generate revenue. They can betangible items like equipment used to create a product. Or assets can be intangible, like apatent or a financial security. Cash is also an asset. On a balance sheet, cash assets andcash equivalents, such as marketable securities, are listed along with inventory and otherphysical assets.

Liquidity of Assets

Assets are listed in order of how quickly they can be turned into cash—or how liquidtheyare. Cash is listed first, followed by accounts receivable andinventory. These are all what is known as current assets. They are expected to be used,collected or sold within the year.

Noncurrent assets follow current assets on the balance sheet. Noncurrent assets include itemssuch as equipment and trademarks. These are assets that can’t be sold for cashquickly.

Most Liquid Assets

Current assets are the most liquid assets because they can be converted quickly into cash.They include cash equivalents, accounts receivable and inventory.

Least Liquid Assets

Noncurrent assets are the least liquid assets because it takes longer to sell them. Theyinclude equipment, buildings and trademarks.

Measuring Financial Liquidity

The concept of liquidity requires a company to compare the current assets of the business tothe current liabilities of the business. To evaluate a company’s liquidity position,financeleaders can calculate ratios from information found on the balance sheet.

What Is a Liquidity Ratio?

Liquidity ratios are a valuable way to see if your company’s assets will be able tocover itsliabilities when they come due. There are three common liquidity ratios.

Let’s calculate these ratios with the fictional company Escape Klaws, which sells thosedelightfully frustrating machines that grab stuffed animals.

Assets

Liabilities

The company also has long-term debt and shareholder equity of $1,000. But those won’tbe usedin the liquidity ratios because they won’t come due in less than a year.

Current ratio. This indicates the company’s ability to repay businessdebtwith cash and cash-equivalent assets, i.e., inventory, accounts receivable and marketablesecurities. A higher ratio indicates the business is more capable of paying off itsshort-term debts. These ratios will differ according to the industry, but in general between1.5 to 2.5 is acceptable liquidity and good management of working capital. This means thatthe company has, for instance, $1.50 for every $1 in current liabilities. Lower ratios couldindicate liquidity problems, while higher ones could signal there may be too much workingcapital tied up in inventory.

That means the business has $2 for every $1 in liabilities.

Acid test ratio/quick ratio. This ratio is more conservative and eliminatesthe current asset that is the hardest to turn into cash. In this case, we’ll eliminatethe$500 in inventory (one machine). A ratio less than 1 might indicate difficulties in coveringshort-term debt.

Cash ratio. This shows the company’s capacity to pay off short-termdebtwith cash and cash equivalents, the most liquid assets. A ratio of at least .5 shows healthycash flow.

Using and Interpreting Ratios

Intuitively it makes sense that a company is financially stronger when it’s able makepayroll, pay rent and cover expenses for products. But with complex spreadsheets and manymoving pieces, it can be difficult to see at a glance the financial health of your company.

Financial ratios are a way to look at your liquidity and measure the strength of your companyat a glance using different scenarios, such as covering liabilities with cash and cashequivalents, accounts receivable and even if you had to sell, or liquidate, some of yourinventory and equipment. These ratios are also a way to benchmark against other companies inyour industry and set goals to maintain or reach financial objectives.

In the example above, Escape Klaws could see quickly that it’s in a good position topay offits short-term debts. The owner would still want to check in regularly and review thefinancial ratios to make sure changing market forces don’t disrupt its financialposition.

Liquidity Examples

In order for an asset to be liquid, it must have a market with multiple possible buyers andbe able to transfer ownership quickly. Equities are some of the most liquid assets becausethey usually meet both these qualifications. But not all equities trade at the same rates orattract the same amount of interest from traders. A higher daily volume of trading indicatesmore buyers and a more liquid stock. Consider a diversity of investments to make capitalavailable when needed.

Balance Sheet Example

A balance sheet is a way to look at how much your company owns and how much it owes at agiven point in time. This is where you’ll find the information you need to create yourliquidity ratios, which help make this information more digestible, easier to track andeasier to benchmark against peer companies.

Using this example, we can calculate the three liquidity ratios to see the financial help ofthe company.

This means the company has $1.33 for every $1 in liabilities.

A ratio of 1 or more indicates enough cash to cover current liabilities.

A ratio above .5 is usually a good indicator of a healthy cash flow.

What Is Liquidity Risk?

The Federal Reserve Bank of San Francisco defines afunding liquidity risk as the risk that a firm will not be able to meet its current andfuture cash flow and collateral needs, both expected and unexpected, without materiallyaffecting its daily operations or overall financial condition. Monitoring these financialratios allows you to better gauge any liquidity risk and make adjustments or take action.

Liquidity vs. Solvency

Liquidity is a measure of your company’s ability to meet short-term financialobligationsthat come due in less than a year. Solvency is a measure of its ability to meet long-termobligations, such as bank loans, pensions and credit lines. Liquidity is measured throughcurrent, quick and cash ratios. Solvency is examined through other ratios, including:

• Debt to assets ratio: How much of your company’s assets were financed throughdebt?
• Interest coverage ratio: Can your company pay the interest expense on its debt?
• Debt to equity ratio: How much of your company’s operations is financed with debt?

Short-term liquidity issues can lead to long-term solvency issues down the road. It’simportant to keep an eye on both, and financial ratios are a good way to track liquidity andsolvency risk.

How Can Liquidity Be Improved?

Finding more and new ways to hold onto and generate cash is a constant search for mostbusinesses. Think about ways to cut costs, such aspaying invoices on time to avoid late fees, holding off on making capital expenditures andworking with suppliers to find the most cost-efficient payment terms. Try using long-termfinancing instead of short-term to improve your liquidity ratio and free up cash to investback in your business or pay off liabilities.

11 Ways to Boost Liquidity

Some of the best ways to boost liquidity include:

1. Increase sales: It may seem obvious, but more sales will mean more cashflow to your business. Expanding your sales force and new marketing initiatives can helpdrive sales. Employing different business models can also stoke sales – forexample,subscription or recurring revenue models, bundling or unbundling offerings. Examine yourprofit margins to inform your pricing. But keep in mind, cash may not come in quicklyenough to keep up with bills.
2. Reduce overhead: Overhead costs don’t directly drive revenue toyourbusiness. Some examples of overhead expenses are wages, rent, office supplies,insurance, and bank or legal fees. Closely examining your overhead can presentsurprising cost savings. For example, business situations change, and insurance premiumsmight decrease as your company matures.
3. Improve invoice collection: NetSuite Brainyard offers some helpful tipsfor optimizing accounts payable processes to ensure cash flow. These include offeringdiscounts in return for quicker payments, sending reminders on unpaid invoices, look tocollect on customers with large payment balances and define weekly cash collectiontargets. Business accounting software can help you send accurate invoices and trackpayment. And the accounts receivableturnover ratio can help you track progress.
4. Pay off debts faster: Liquidity ratios look at assets and debt thatwill come due in less than a year. Paying down debt will improve your liquidity ratios.Don’t dip too far into cash savings to cover all debts, however. Be sure toanticipateexpected and unplanned expenses.
5. Sell your assets: Are there assets your company has that aren’thelpingdrive revenue? These are known as unproductive assets and can often be sold to increasecash reserves. Examples include outdated or redundant equipment, unused vehicles orproperty with no plans for development.
6. Refinance your debt: Move from short-term to long-term debt whereappropriate. This can lower interest rates and have smaller monthly payments giving youmore flexibility to meet short-term financial obligations.
7. Manage accounts payable: Efficient management of accounts payable can also boostyour company’s liquidity. When they’re offered, take advantage of discountsfor earlypayment, and negotiate longer payment terms with regular suppliers when they’renot.Don’t pay suppliers early when there’s no financial incentive to do so. Andifnecessary, prioritize payments to key suppliers to keep your business running.
8. Watch inventory: Don’t tie up cash in inventory. Closely monitortheinventory to working capital ratio and achieve a balance that is in line with theindustry in which the business operates.
9. Examine and reduce operating costs: When facing abudget shortfall, common areas to cut expenses include business travel, office space,marketing budgets and salaries and bonuses.
10. Take advantage of PPP loan forgiveness: The U.S. Small Business Administration recentlyannounced that it would forgive some 70% of PPP loans – including all of thosethat werefor $50,000 or less and even for sole proprietors.
11. Prepare a cash flow projection: NetSuite Brainyard recommends listingall future cash inflows and outflows in cash flow statementsby week or month and making sure to calculate ending cash balance at the end of eachweek or month. This will help the business predict when cash balances may dip below anacceptable level.

How Can Accounting Management Software Help?

Accounting software helps a company betterdetermine its liquidity position by automating key functionality that helps smooth cashinflow and outflow. NetSuite FinancialManagement automates more accounting processes and gives you and your finance teameasy access to data for analysis – with high impact functions to automate includinginvoicing, financial report generation, data collection and document storage, andcompliance.

The Federal Reserve Bank of Chicago’s analysis of the financial health indicators ofsmallbusinesses demonstrated a need for caution in placing too much stock in revenue growth as anindicator of financial health. By taking other measures into account, such as liquidity, abusiness can make changes to ensure it’s able to meet its debts, maximize the time itholdsonto cash and ensure that if it needs funding from a bank or investor it’s in the bestpossible position to get that capital.