Have you ever wondered what liquidity in business is? Liquidity in business is something that all business owners and operators should be aware of – and fortunately, our team is on hand today to help you find out more about what business liquidity is and how understanding this can help your company. So, without further ado, let’s take a look at what liquidity is in businesses and what it means for your firm!
What is Liquidity in Business
First of all, we need to look at what business liquidity means before considering why this is so important. Business liquidity relates to the company’s ability to pay its existing liabilities. In other words, it assesses the company’s current financial position and its outstanding debts and invoices to determine whether the business can meet its financial obligations. Short-term liabilities are usually measured over a year.
Calculating your business’s liquidity is a crucial aspect of effective company management; however, it is not necessarily a straightforward calculation, as it can depend on numerous factors.
What is Considered as Part of my Liquidity in Business (Business Liquidity) Calculations?
Of course, the simplest form of asset to consider is your business’s financial savings; if the company has more than enough financial savings to cover all upcoming expenses, it can generally be said that its financial health is good.
However, savings alone are not the only form of assets that can be considered when considering business liquidity; your firm should also consider its physical assets as part of this calculation, or any stocks and bonds that the business holds, when considering the company’s financial position.
Assets are often trickier to factor into business liquidity calculations, though, as some assets are said to be liquid (generally those that can be sold quickly), while others are illiquid (i.e. assets which take time to sell, such as niche items or items that have a specific selling time).
For assets to be liquid, they need to have a well-established existing market and buyers lined up and ready to make a purchase almost immediately. To this end, stocks and shares are usually classed as liquid assets, as they can be sold rapidly. However, a business’s products may be considered illiquid if the market is not readily available to purchase the items at almost the drop of a hat.
Why Liquidity is Important for Businesses
There are a considerable number of reasons why understanding your business’s liquidity is essential. Nevertheless, the three most prominent of these are for management purposes, securing loans or funding, and as an industry benchmark. We’ve briefly summarised the importance of these three points below to give you further insight into why your business should consider its liquidity.
1. Financial Health Management
Understanding your business’s liquidity is a crucial component of monitoring the firm’s financial health. Of course, we shouldn’t need to go into great detail about the importance, as one of the essential components of effective business management should include meeting your business’s financial obligations and debts.
Nevertheless, it’s also crucial that your firm can set aside funds and investment to grow and expand into new markets and opportunities – and, as such, finding a balance between financial obligations and growth opportunities is crucial.
Understanding business liquidity is a crucial aspect of this decision. Indeed, business liquidity can allow you to monitor how easily your business can pay its debts. This, in turn, gives you a clearer understanding of how much your business can safely afford to invest in new opportunities without putting itself in dangerous waters in terms of business profitability.
2. Securing Funding
Another reason why your business should consider the importance of liquidity is for financing and funding purposes. While financial liquidity is essential for determining whether your business can afford to invest, it’s also crucial for securing loans or funding solutions.
Indeed, banks and lenders will consider your business’s liquidity as part of their decision on whether or not your firm could be a safe investment. This will impact the terms and interest rates your business pays for the loan and could even be the difference between being offered a loan or not.
Comparing your own business to other companies within your niche or sector can offer precious information, and to this end, this might be something that you want to consider. Assessing your business’s financial liquidity against other high-performing businesses in your sector can offer a simple way for your firm to determine its success and identify opportunities and areas for growth.
Calculating the Cash Ratio for Business Liquidity
At this point, we should briefly summarise how to determine your business’s liquidity for short-term debts. Fortunately, this calculation is a relatively simple one to carry out, although there are a couple of steps involved.
First, calculate your current assets (sum of cash, accounts receivable, and inventory value). Then, calculate your current liabilities (sum of accounts payable, accrued expenses, and inventory). This information will give the information you need to begin determining your business’s financial position.
To calculate your current ratio, divide your current assets by your current liabilities. This is the most straightforward calculation and shows the value of assets per pound sterling of liability. However, it includes illiquid assets that may be hard to sell.
As such, a more valuable ratio can be the acid test ratio, which does not account for the value of inventory in your business. To calculate the acid test ratio, subtract the inventory value from your current assets, and divide this by your current liabilities. A score of 1 or greater will usually be indicative of a stable financial position for short-term debt.
Finally, you could calculate the cash ratio for your business. This goes a step further and doesn’t consider either money owed to your business or your business’s inventory – giving insight into your business’s ability to pay its debts immediately with just the financial savings it holds. To calculate the cash ratio, divide the value of the business’s total cash and cash equivalents by the current liabilities; a score of 0.5 or greater is usually considered a healthy business cash flow.
Today, we’ve summarised liquidity in a business setting and why promoting liquidity is crucial for firms. However, if you still have any additional questions or want to find out more about your firm’s liquidity, then our team is on hand today to help with this. Get in touch with us to learn more about business liquidity and its importance today; we’re here for you!
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