As a business owner, it’s pretty much impossible to avoid having financial obligations.
From employee wages and unpaid taxes to office lease payments to utility bills, there’s always a checklist of items that you need to pay off each year.
When you want to know if your company is able to swiftly handle these liabilities, you need to measure your company’s liquidity.
So what is liquidity exactly?
Liquidity is a basic business term that you need to be familiar with in order to get the full picture of your company’s financial health.
It allows you to grasp exactly how secure you will be in the face of sudden expenses, as well as whether or not you can truly handle the obligations you currently have.
In this article, we’ll walk you through what liquidity is and help you calculate your accounting liquidity.
What Is Liquidity?
Liquidity is best defined as how quickly assets can be sold without impacting their true price.
When used in reference to small businesses, this term can further be defined as how easily you can cover your short-term debt, including any financial obligations you need to meet within the next 12 months.
This is called accounting liquidity.
Accounting liquidity measures the liquidity of a single company at one time, allowing you to get strong insight into your financial health.
While this mainly informs you about your ability to pay off short-term obligations on the surface, it allows you to further understand whether or not you’re equipped to handle a financial crisis or any immediate need for large sums of money.
It also helps you catch issues with your cash flow early on.
It’s important to know that accounting liquidity is distinct from market liquidity.
The latter tells you about how the conditions of an entire market — such as the stock market or the real estate market — and how successfully an individual or company can sell off assets.
While it can be helpful to pay some attention to market liquidity, we’ll focus on accounting liquidity in this article to help you get the most transparent view of your own business.
What Are Liquid Assets?
When you’re learning how to read a balance sheet, you’ll find that all assets are traditionally listed in order of liquidity.
This is because some assets are far more liquid than others, meaning that they can more quickly be converted into cash.
Here’s a short list of liquid assets, in order of their liquidity:
- Cash: This is easily the type of asset with the most liquidity, as it’s already in the form we’re trying to convert to.
This means it will retain its full value.
- Securities: These include bonds and stocks, which can be traded for their cash equivalents within a couple days.
However, this only applies to marketable securities.
Stocks and bonds with extremely low trading volumes can be rendered illiquid due to lack of demand.
- Physical commodities: These are raw materials that are used to create your products, such as soybeans in the agricultural industry.
Just because an asset doesn’t have high liquidity doesn’t mean it’s not valuable.
It simply means that you can’t turn it into cash quickly due to either lack of marketability or high value.
For example, real estate is sometimes considered an illiquid asset due to the fact that it’s highly valuable, so the only way to sell it off quickly would be to sell it far below its true price.
In this case, real estate isn’t dependable for quick cash, since it often takes months or even a year to sell.
How to Calculate Your Liquidity Ratio
When your creditors want to determine your ability to pay them back, your liquidity ratio is one of the first things they look at.
Primarily, they’re looking at this measure of accounting liquidity to ensure you can be trusted to pay back loans.
Now that we’ve fully answered our initial question — “What is liquidity?” — we’ll show you three ways to calculate your liquidity ratio, so you can best measure your company’s ability to pay off short-term obligations.
As you learn about the formulas that you can use, keep in mind that any ratio greater than one is a sign that your company is in a decent financial state.
The higher you get, the more secure you are against your current liabilities and potential emergencies in the future.
However, if your ratio gets extremely high — for example, above three — this could be a sign that you’re not maximizing your company’s growth potential by investing back into it.
1. Current Ratio
Also known as working capital ratio, current ratio is the easiest liquidity ratio to calculate.
This is because its formula directly compares the two primary factors in liquidity: your current assets and your current liabilities.
The current ratio formula is as follows:
Current Ratio = Current Assets ÷ Current Liabilities
This formula is an efficient way to get an overview of your company’s liquidity, but its downside is that it doesn’t account for the fact that not all assets are liquid assets.
Though current ratio is still a fairly trustworthy measurement, it can be helpful to spend a bit of extra time calculating our next ratio.
2. Quick Ratio
The quick ratio, sometimes known as the acid-test ratio, increases the accuracy of your accounting liquidity measurement by isolating your liquid assets from your illiquid assets.
The formula is as follows:
Quick Ratio = (Cash and Cash Equivalents + Short-Term Investments + Accounts Receivable) ÷ Current Liabilities
As you can see, this formula replaces your general grouping of all current assets with specific types of assets that can be converted into cash quick — hence the name of the given ratio.
This ensures that your liquidity ratio doesn’t account for assets like inventory and equipment, which often results in an overestimation of your accounting liquidity.
3. Cash Ratio
Your cash ratio is the best measurement of your liquidity to use when you want to determine your ability to handle the worst possible situations, where you need cash immediately or within a couple days.
This ratio also limits included assets to those that can be traded in a snap.
Here’s the formula for your cash ratio:
Cash Ratio = (Cash and Cash Equivalents + Short-Term Investments) / Current Liabilities
The biggest difference here is that accounts receivables are no longer included, as you can’t guarantee that a debtor will pay you back immediately when you need the money.
Frequently Asked Questions
Now that you know exactly what liquidity is, as well as how to measure and act on your company’s liquidity ratio, you can continue tracking it and smoothing out any bumps in your cash flow.
Here are our answers to some common questions that may help you out:
1. How can I improve my accounting liquidity?
If your liquidity ratio falls below one or if it’s too close to one for comfort, there are many actions that you can take to improve your financial health.
The best goal to create for yourself in this scenario is reducing your current liabilities as much as possible, so you may choose to:
– Reduce overhead expenses by saving on utilities and professional fees or even finding a workspace with lower monthly rent.
– Negotiate longer payment periods with creditors and vendors so they don’t count toward your short-term obligations.
– Pay all contractor invoices immediately, or at least early on.
2. How does liquidity differ from solvency?
Both liquidity and solvency are common measurements that tell you about your company’s ability to pay off debt.
However, liquidity is focused on short-term obligations, while solvency is focused on long-term obligations.
Solvency is more often used to measure financial vitality over a long period of time.
3. How often should I calculate my liquidity ratio?
Liquidity should be calculated at least once per year to cover all your annual financial obligations.
You may also find it helpful to estimate liquidity whenever you take on a large short-term bank loan to ensure your assets can cover it quickly.
Maintain Your Financial Health
When you calculate your company’s accounting liquidity on a recurring basis, you’ll be able to make better financial decisions.
Being aware of your ability to handle short-term debt will inspire you to keep the value of your assets high and your liabilities low, so you never fall below a ratio of one.
If you want to learn about another effective way to measure your company’s ability to manage cash flow, while also getting insight into your sales, read about inventory turnover and how it can affect your company.