Liquidity - What does it mean and how it’s used in business?

Market Liquidity and Accounting Liquidity

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Market liquidity defines if assets within a certain market can be bought or sold with steady and transparent pricing. 

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For instance : buying any asset will be easier and quicker with cash than if you had to sell off your art collection to do so, right? Well there you go! You just understood market liquidity!!

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Obviously, the most liquid asset you can have is actual cash, as it is already available to be used at equal valuation. Other assets ranging from your company car, to real estate have different levels of liquidity.

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Most liquid assets: 

• Cash and equivalent
• Marketable securities
• Financial assets
• Accounts receivables

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Least liquid assets:

• Inventories
• Investments
• Appliances & equipment
• Land, buildings, plants
• Art and collectibles

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Accounting liquidity is a measure of your business’ ability to honour short term liabilities, taking into account your current assets. It’s quite simple, bear with us! 

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Short term debt, or current liabilities are the amounts that must be paid to creditors within the year for taxes, bank loans, accounts payable, wages, lease payment. Sorry to remind you about all those by the way…

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Current assets include your bank balances, the accounts receivable (the revenue you are still owed), and your liquid assets (available cash).

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Liquidity can be measured with different ratios that can help you to assess the health and development of your company - such as solvency and profitability. But let’s stay focused on liquidity for now! It is after all the point of this article!

“Want a bit of knowledge to share with your friends? Just before the Renaissance, Italian bankers were the absolute bosses in the game. They used the term Liquido to qualify an easy, flowing, fast sale or transaction. The word buzzed hard, and it stuck! They were the business influencers of this time after all!”

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Why is liquidity important for my business?

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In a few words, liquidity highlights the short term health of your company, and how much breathing room you have financially to meet your debt!

“Liquidity is used to qualify how easy it is to convert an asset into cash. Money in a bank account is the most liquid element for a company, because it can already be used to pay for things, right?”

Knowing your liquidity is very important to third parties too! How would you feel lending money to someone who owes more than they have? It's not 100% safe -  that’s for sure!

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It’s the same for your business! Liquidity is useful and insightful for you, sure! But it is also a great metric for others to assess your capacity to pay off debt in the short-term to banks and investors! 

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Eager to see how it’s done?

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How do you calculate liquidity?

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As often in the finance world, there are several ways to measure liquidity! The two main ones are the Current Ratio and the Quick Ratio. 

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So which one do I need then?

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Well it depends on the industry and type of business you’re in, and most importantly how long it takes on average for you to sell your inventories!

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“The stock of ground beef from the neighbourhood food truck is used to make burgers that are then sold. So it becomes cash relatively quickly! If, very differently, you sell luxury watches, they will surely stay longer in your store (unless you do not close your showcases)!”

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The Current Ratio

If for instance you run a supermarket or a ashop that sells its stock fast, you will want to calculate your Current Ratio! It measures your current assets against l your current liabilities. Here’s the formula, but we also wrote a whole article about it if you want to find out more!

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CURRENT ASSETS ÷ CURRENT LIABILITIES = CURRENT RATIO

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The Quick Ratio

If you sell high-end products (furniture, appliances, and such) you’re better off using e this metric! It still measures your ability e to pay off short term liabilities, but leaves out your stock. 

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The formula is below ! But, we also have a detailed article on this! 

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CURRENT ASSETS - INVENTORIES ÷ CURRENT LIABILITIES

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How do you analyse liquidity?

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Ok, so, in a nutshell, liquidity is calculated through different ratios which highlight if you have enough money to pay what you owe in the short-term.

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Alright, is there a specific number to reach?

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Mostly yes! For each ratio there are thresholds that your company should be above! 

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Concerning the Current Ratio, you should be aiming for 1.5:1 as a minimum. Above it you are considered to have sufficient liquidity. But sectors will influence the benchmarks! So compare your results to others from the same industry. 

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For the quick Ratio, you simply need it to be equal or above 1:1. At this point your company is liquid enough to honor its short term liabilities. As stockeis not included, it sums up what can be converted into cash quickly!

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Also keep in mind that having a high ratio is good, sure! But it could also mean that your cash flow is poorly managed and could be put to better use! 

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Quick tips on improving your liquidity

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Now that we know how to measure liquidity, we have a few tips for you to improve  your liquidity.

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Improving your receivables management 

This is a good way to boost your liquidity! For many companies, the time between the sale and the moment they receive the money can be days, weeks, and even months! If, say, a third of your customers pay their invoices late, it will influence your liquidity tremendously!

“Watch out for those friends! Poor management of customer receivables can have a huge impact on your liquidity! So set up a process for recovery and validation of the payments you are owed!”

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Rethinking your stock and hard assets 

This can also help improve your liquidity. If for instance you have several fancy offices or a fleet of company cars, your liquidity will be lowthrough the short term obligations they represent. Maybe it’s time to sell off some hard assets to turn them into liquid assets!

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Offer visibility to investors and banks. 

In both cases, having good liquidity should put you in a more confident position to either borrow or bring in capital. It means that you will be able to pay your debts and the interest to the bank. It means people investing in your business have a better chance of seeing their money back and/or being paid dividends.

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Track your liquidity and manage your cash flow better with Trezy

We’ve just seen how important your liquidity is! But can you imagine the amount of time it would take to calculate it on a regular basis? And this is only one type of metric among many other ratios! 

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Today’s company leaders have limited time and better things to do! 

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Tax sheet here, invoices there… Oops, what about that excel sheet you haven’t updated in weeks. The One that doesn’t reflect your day to day reality anymore?

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With Trezy, all your incoming and outgoing transactions are compiled & categorised. Allowing you to monitor your current cash position, and plan into the future.

You have a real time, 24/7 overview of all your company’s finances, which allows you to take quick and swift business decisions.

With scenario mode, you can set up your own cash flow forecasts, or let our AI do the work. Let Trezy be the financial brain of your business!

“There are several ways to improve your liquidity! But the best thing is to make a cash flow forecast with all your data... You know it! You didn’t? Well now you know!”

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Want to start a free trial and start managing your finances with ease? Or if you feel like you could use some help, why not ask for a demo?

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Interview with “Le Khey de la compta” - The Accountancy Bro

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“Le Khey de la compta”, literally “The accountancy bro” defines himself as the most irreverent accountant soon to be chartered by the public system. You can follow his funny tweets and posts on instagram @comptabeasy 

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Can you help us understand liquidity?

Liquidity is used to qualify how easy it is to convert an asset into cash. Money in a bank account is the most liquid element for a company, because it can already be used to pay for things, right?

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Here is a bit of knowledge to share with your friends? Just before the Renaissance, Italian bankers were the absolute bosses in the game. They used the term Liquido to qualify an easy, flowing, fast sale or transaction. The word buzzed hard, and it stuck! They were the business influencers of this time after all! 

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Actually nowadays in France, we still say “liquide” to designate cash money. And the English term cash flow also evokes this liquid notion. Feel smarter already? 

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Awesome, any tips on how to improve it?

You can start with receivables! It is the invoices not paid yet that can be converted into cash fairly quickly. For a lot of businesses, it’s over 1 or 2 months maximum. Watch out for those friends! Poor management of customer receivables can have a huge impact on your liquidity! So set up a process for recovery and validation of the payments you are owed!

Depending on your business, your stock will be sold at different speeds, and this is very important to take into account for your cash flow!

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Example: The stock of ground beef from the neighbourhood food truck is used to make burgers that are then sold. So it becomes cash relatively quickly! If, on the other hand, you sell luxury watches, they will surely stay longer in your store (unless you do not close your showcases)!

‍

There are several ways to improve your liquidity! But the best thing is to make a cash flow forecast with all your data... You know it! You didn’t? Well now you know!