There are many different factors that have a crucial impact on the life flow of a business. These factors influence the company’s ability to grow and expand, ultimately contributing to its success or failure. One of these essential factors is liquidity. What is liquidity in business and why is it so important? Let’s start answering this question by looking at what the term “liquidity” actually means.
What Is Liquidity In Business?
Liquidity in business refers to a company’s ability to raise cash when it needs it. It measures the company’s ability to meet their short term financial obligations by converting assets into cash. This means that a company with “high” liquidity is one that can raise cash quickly without needing to increase borrowing. A company with “low” liquidity on the other hand, is one that struggles to convert assets to cash swiftly, and therefore struggles to meet their short-term obligations. If a company has low liquidity, this can be an indication that they are struggling with cash flow and are under economic stress.
How Is Liquidity Measured?
Now that we’ve established the answer to our initial question of “what is liquidity in business”, you’re likely to be wondering how it’s measured. There are two main ratios that are used to determine this. These are:
Current Ratio: Also referred to as the “working capital ratio”, this calculation involves dividing the company’s current assets by its current liabilities. “Current assets” are those that can be converted into cash within one year, whilst “current liabilities” are those that can be paid off within a year. Industry standards will of course vary, however, generally speaking, any ratio below 1 is considered a cause for concern. If the current ratio suddenly falls then this could be an indicator that the company is facing financial difficulty.
Quick Ratio: Sometimes referred to as the “acid-test ratio”, the quick ratio uses the same formula as the current ratio, however excludes inventory from the calculation. This is because inventory is not as liquid as other assets, such as property. In other words, it’s not as easy to convert to cash without losing value.
Why Is It So Important?
So, we’ve answered the question of what is liquidity in business, and how it’s calculated, but why is it so significant? Primarily, liquidity is essential for ensuring that your company has sufficient means to meet their immediate liabilities. If a company is struggling to raise cash to pay its liabilities, this can result in debt stacking up, which could lead to more serious long term problems. It’s also important to know that the business has enough liabilities to make payments quickly in the event of an emergency. In addition to this, creditors will look at liquidity as an indicator of how stable and strong a company is. When discussing the topic of “what is liquidity in business”, it’s important to emphasise its importance internally as well as externally i.e. for investors looking in.
Monitoring your company’s liquidity will give you a strong indication of whether you can put plans in place for growth, or if your business is under financial strain. If you are concerned that your business has low liquidity, or is struggling with cash flow problems, it’s important to address the issue proactively. Seeking the advice of a professional business rescue expert as soon as possible will provide you with the best options for returning your business to profitability. Please don’t hesitate to get in touch with the team at Ballard Business Recovery today for confidential advice.
