Short Term Positioning: The Importance of Liquidity

by Greg DePersio

2 min read

When managing a small business, the most important aspect to maintain is cash. Everything related to your business returns to the concept of having the ability to finance the business. Do not underestimate the importance of maintaining high liquidity.

Cost of Running Out of Cash

Running out of cash is not optimal. The inability to pay staff wages on time, order inventory or pay monthly bills such as rent comes at a price. Having to take out short-term emergency loans will impact your personal credit score or increase the risk related to your company. Higher interest rates will be imposed on these loans, especially as your company is assessed with high risk. Although your company can still earn revenue through sales, the cash aspect of the transaction is vital so you can smoothly operate your business.

Utilizing Liquidity Ratios

The best way to determine your company’s liquidity is to implement an analysis process including liquidity ratios. These financial metrics convert balance sheet items into specific calculations that establish a relative level of liquidity. For example, just because a small business has $100,000 cash on hand doesn’t necessarily determine whether the company is liquid or whether the figure is sufficient, because all companies and industries are different. Liquidity ratios help scale operations and create comparable figures.

  • The current ratio divides current assets by current liabilities. This measures your company’s ability to cover short-term debts with all short-term assets.

*T he quick ratio compares only the most liquid assets – cash and accounts receivable – to current liabilities. This measures your company’s ability to pay current bills using only the assets easiest to convert.

  • The working capital ratio subtracts current assets from current liabilities. This measures the cash flow available after current bills are paid.

All three of these metrics can be used to analyze and maintain the appropriate balance of current assets and current liabilities.

Impact on External Parties

Liquidity directly impacts your ability to get loans from investors. External parties are highly interested in knowing your ability to pay off these loans, both in the short term and the long term. Although more emphasis may be placed on your company’s overall solvency, a financial institution will analyze your liquidity before issuing a loan. Having poor liquidity will result in a rejection of a loan, lower loan dollar amounts than requested, higher assessed interest rates or more debt covenant restrictions.

Ideal Cash Reserve

Determining your ideal cash reserve is a balancing act. On one hand, you want to have more than enough cash in case of emergencies. However, having resources tied up in cash limits your ability to use the funds towards your business. In addition, cash loses purchasing power in an inflationary market, so this means the more cash you have on hand, the higher risk you run of actually losing money by holding cash.

Look at cash flow projections from the next 12 months to create forecasts. A startup should plan for higher liquidity in case of unexpected expenses. More established businesses can rely more on accounts receivable and inventory turnover, so this liquidity should be in easily convertible goods.

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