What is liquidity? A guide for small businesses

What is liquidity in business and why is it important? Read on to find out about liquidity planning, liquidity risks, and how to improve liquidity in a business.

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What is liquidity in business?

The liquidity meaning is how easily a business can settle short-term liabilities such as bills, tax, and loans with its current assets.

A business with high liquidity can meet its financial obligations quickly without needing to take on extra debt such as a loan, or sell its most valuable assets.

The more liquidity a business has, the easier it can raise cash quickly to pay for extra costs or unexpected losses.

Cash is the most liquid asset of all as it can be used to pay for things without being converted or sold.

Other common business assets include:

• equipment
• stock
• buildings
• investments
• land

Some assets, such as investments, are easier to convert into cash which means they have a higher liquidity.

On the other hand, assets like equipment and premises will take longer to convert into cash, so they’re seen as having lower liquidity.

What’s the importance of liquidity in business?

Businesses could encounter financial problems if they have low liquidity and can’t generate cash from their assets quickly.

For example, if a business unexpectedly loses a high-paying customer and doesn’t have assets that can be converted to cash quickly, it may struggle to make up the shortfall. As a result, it could have issues paying bills or wages.

These kinds of problems could lead to insolvency, which is when a business can’t pay any of its debts.

Insolvent companies often have to sell off their most valuable assets for low prices, and even then they may have to declare bankruptcy and stop operating.

Managing uncertainty and attracting investment

A business with high liquidity is in a better position to adapt to unexpected financial changes or operate effectively in an uncertain market.

Consider for example that all businesses have had to deal with the impact of the Covid-19 pandemic.

Some businesses may have experienced a sharp fall in customers or revenue in a short time. If they had low liquidity, they may have struggled to pay off short-term liabilities.

Liquidity is not only needed for your business to survive and grow, it’s also useful if you’re looking for investment.

Angel investors or venture capital firms will often assess a company’s liquidity before making an offer.

What is liquidity planning?

By monitoring your short and medium-term cash flow, while taking a long-term view where possible, you can get an idea of the liquidity of your business.

You’ll need to track the costs of things like:

• loans
• interest
• business rates
• tax
• wages

Although it’s hard to predict what your customers are going to do, it’s important that you keep track of customer activity and revenue alongside your outgoings.

Two of the most useful tools you can use to do this are a budget and cash flow forecast. Download our free budget template and cash flow forecast template to get started.

To understand the liquidity of your business, you’ll also need to have a clear view of your current assets and how they could change in the future. This can help you to make sure you have enough liquidity in the event that you need to raise cash quickly.

We’ve got a range of guides to help you with liquidity planning:

• how to do a balance sheet
• guide to bookkeeping for small businesses
• what is EBITDA

What are liquidity risks?

An asset that has low liquidity will often be seen as a liquidity risk. Take the example of a company owning equipment that it needs to sell to make up for a shortfall in income.

If it’s difficult to sell the equipment at its market value due to a lack of demand, it can be considered a liquidity risk.

Any business that risks not being able to meet its financial obligations because of its assets is experiencing liquidity risk.

How to work out the liquidity of your business

There are several ratios used to work out the liquidity of a business, including:

• current ratio – dividing current assets by current liabilities
• quick ratio – the same calculation as the quick ratio, excluding stock. Also known as an acid-test ratio
• cash ratio – working out all of a business’s assets as cash or cash equivalents to see how it would cope in a worst-case scenario

A company with a current or quick ratio of less than one is likely to be experiencing liquidity risk. A ratio of between one and three is usually a sign of a company with healthy liquidity.

However, if a company’s liquidity is too high it could indicate that it’s not managing its finances effectively. This could have a negative impact on business growth.

How to improve liquidity in business

If a business has low liquidity, there are steps you can take to reduce risk and get things back on track.

Here are some of the most common ways to improve liquidity:

• pay off liabilities – reducing debts such as loans, interest, or taxes can increase the liquidity ratio of a business
• use long-term financing – short-term financing like a bridging loan can be costly, so look for more long-term options if you need a cash injection
• cut back on costs – reducing marketing spend or moving to a cheaper office can help businesses to increase liquidity
• use sweep accounts – this is when a business moves money that isn’t needed into high interest bank accounts to earn extra revenue

It’s also important to look at the revenue you receive from customers – are you getting paid on time? Download our late payment letter template to help you increase cash flow.

On the other hand, negotiating longer payment terms with your suppliers can keep cash in your business for longer and increase liquidity.

Do you have any unanswered questions about liquidity in business? Let us know in the comments below.

Photograph 1: Viacheslav Lakobchuk/stock.adobe.com

Photograph 2: BullRun/stock.adobe.com