Liquidity in Small Business: What It Means and Why It Matters
Liquidity for a small business means the ability to cover its short-term financial obligations. It refers to the ease with which the assets can be converted to cash.
By calculating and tracking different ratios of your company’s assets and liabilities, you can measure your business’ liquidity. This is necessary for spotting cash flow problems and checking if your business is in good financial health.
What this article covers:
- What Is Liquidity in Accounting?
- What Is Liquidity Ratio?
- Why Is Liquidity Important?
- How Can Liquidity Be Improved?
NOTE: FreshBooks Support team members are not certified income tax or accounting professionals and cannot provide advice in these areas, outside of supporting questions about FreshBooks. If you need income tax advice please contact an accountant in your area.
What Is Liquidity in Accounting?
In accounting, liquidity is the ability of the current assets to meet the current liabilities. It is the number of liquid assets of a business that can be traded in the market without losing its value. The current assets can be turned into cash within a year and are available to pay short-term expenses and debts.
What Are Examples of Liquidity?
Since it can be used to pay off debts and make purchases quickly and easily, cash is considered the standard measure of liquidity. The other current assets are listed in the order of liquidity, which is the order in which they are expected to turn into cash.
Assets such as stocks are easily converted into cash and they are higher up in the order of liquidity. Other liquid assets include saving accounts, accounts receivable, time deposits, mutual funds, U.S. Treasuries and bonds.
Assets such as land, equipment and buildings are the least liquid assets as it could take months to sell them
A small business is considered to have a high level of liquidity when it has large amounts of cash and other current assets that can be converted into cash at short notice.
What Is Liquidity Ratio?
Liquidity is usually presented as a ratio or a percentage of current liabilities. There are three common ratios used to measure a business’ liquidity.
The current ratio, also known as the working capital ratio, is calculated by dividing the current assets (cash, temporary investments and accounts receivable) of a business by its current liabilities.
Current ratio = current assets / current liabilities
These are the short-term assets and liabilities that are consumed and paid off in less than a year. It gauges the business’ ability to pay back its short-term liabilities with short-term assets. If you have a current ratio of 2:1, you have a financially healthy business.
Also known as the acid test ratio, it measures the company’s ability to meet its liabilities with only quick assets such as cash, cash equivalent, short-term investments and current receivables. This ratio does not take into account current assets like prepaid expenses and inventory.
Quick ratio = (cash equivalents + marketable securities + accounts receivables) / current liabilities
The cash ratio considers only cash and cash equivalent into account. It is the strictest and the purest liquidity measure of a business.
Cash ratio = (cash + cash equivalents) / current liabilities
Creditors and investors use the liquidity ratio to gauge how well a business is performing.
Why Is Liquidity Important?
Liquidity means accessible funds. As a small business owner, you know how crucial it is to maintain the cash flow in the business. In fact, it is the single most element of survival for small businesses and start-ups.
Most business owners mistake profits for liquidity. The difference between the two is the time. When you sell a product, you make a profit but that does not equate to cash flow as money takes time to reach your account. Which is why you need to focus on liquidity and managing your cash flow.
Here are some reasons why liquidity is important for small businesses.
- A healthy liquidity ratio helps creditors determine your creditworthiness and secure your business the credit it needs.
- You will need liquidity in case of emergencies.
- Comparing and keeping a close eye on the liquidity allows you to make smart decisions about your finances.
- You can spot financial snags and liquidity crisis before they start to snowball.
How Can Liquidity Be Improved?
To maximize liquidity and maintain a positive cash flow, you can take the following steps.
- Take a personal loan
- If you have unpaid invoices, consider finance through factoring
- Reduce your overhead expenses such as rent, utilities, insurance and professional fees
- Shed unnecessary assets that you seldom use and no longer generate profits
- Submit your invoices early and work hard to make the clients pay
- Negotiate longer payment cycles with vendors
The insights into liquidity management can help you secure constant cash flow for your small business and pave the road to a solvent future.