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If you want to evaluate the health of your small business, you can look at your sales revenues, profit margins, and return on investment. Sales revenues are the fuel that keeps your company running and your cash flow, well, flowing. And when your revenues increase, there is a good chance that you will see more significant profits. But there is another metric that can help you measure the overall health of your business. Again, we are talking about liquidity in small business, which should not be overlooked in favor of the bottom-line sales results.
Liquidity may seem confusing, but it is relatively simple to understand. In a nutshell, liquidity is the amount of cash your small business has to pay bills, meet debts, or invest in equipment, technology, expansion, and marketing. The goal is to achieve a high liquidity ratio, which can put you in the driver’s seat when meeting your short-term financial obligations or investing in your company’s future. If you are looking for a liquidity definition, you will find it in this Balboa Capital blog article. Read on to learn more.
Why is liquidity important?
As mentioned above, liquidity refers to your business’s ability to meet financial obligations at any time. For example, if you cannot pay your suppliers or vendors on time or pay your company’s bills, such as rent and utilities, you have low liquidity, which isn’t good. Low liquidity can lead to excess debt and unfavorable credit ratings and sometimes cause a business to fail. So, you must manage your business’s liquidity and balance sheets and address potential liquidity shortfalls.
Liquidity also plays a role when applying for business funding. The liquidity of your small business is essential to consider when deciding what financing option to take. A lender will want to know that your business has enough cash flow to repay the loan or credit line and that you will continue generating enough cash flow.
What is an example of business liquidity?
An independently owned furniture restoration business has a monthly business loan payment of $4,000, including principal and interest. The company has seen an influx of business in the past year and exceeded profit expectations. As a result, the owner of the furniture restoration business was able to make the monthly loan payments without any problems plus boost the company’s working capital.
Then, signs of a recession began showing, and, as a result, the furniture restoration business saw a dramatic drop in orders. As a result, homeowners in the town where the restoration business is located would save their money during uncertain times rather than have their furniture restored. Fortunately, the furniture restoration business had $40,000 cash and liquid assets worth $50,000. So, the company’s high liquidity enabled it to continue making its monthly loan payments until the recession subsided.
How do you calculate liquidity?
There are three different liquidity ratios that you can use to calculate liquidity: Current ratio, quick ratio, and cash ratio. By periodically calculating your business’s liquidity, you can get an idea of its ability to pay the short-term debt, liabilities, and operating expenses.
The current ratio (CR) measures a business’s short-term financial strength. It is calculated by dividing current assets by current liabilities, including payroll, loans, and other business-related expenses. The current ratio can be interpreted as “what are my business’s chances of not being able to pay off its debts?” Generally, the higher the number, the better the business’s chances of not going bankrupt. Most financial experts agree that a good current ratio falls between 1.5 and 3. For example, a ratio of 2 indicates that the small business has two times more assets than liabilities.
Current ratio = Current assets ÷ current liabilities
The quick ratio, also referred to as the “acid test ratio,” is similar to the current ratio in that it measures a business’s assets against its liabilities. The only difference is that the assets in the quick ratio formula only include liquid assets, such as cash and accounts receivable. Therefore, business owners must exclude their company’s inventory and goods when calculating the quick ratio. Generally speaking, a quick ratio of 1.0 or higher is healthy since the business has enough assets to cover its short-term liabilities.
Quick ratio = Current assets – inventory – expenses ÷ current liabilities
The cash ratio is another important financial indicator for any company. It is defined as a business’s cash, cash equivalents, and short-term investments divided by its current liabilities. The higher the ratio, the better it is for a company. Conversely, the lower the ratio, the more likely the business will be unable to pay its bills and meet its financial obligations. It is commonly agreed that a cash ratio of 0.2 to 1 is ideal and that anything over 1 means that the business has cash assets that are much too high.
Cash ratio = Cash ÷ current liabilities
Small businesses need liquidity to cover their day-to-day expenses, make investments, pay dividends and finance new projects. A lack of liquidity can quickly lead to bankruptcy if not appropriately managed. Conversely, companies with high levels of liquidity will have more options available when seeking business funding or when faced with difficult situations, such as sudden changes in market conditions or economic downturns.
Finally, a company’s liquidity will generally depend on its business type and the risk associated with its assets. For example, a company that sells expensive products may have high liquidity because it will not need to sell many items to generate enough revenue for a day’s expenses.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.