Once you initiate your dream of a startup, you will realize that there are numerous concepts that you had no prior idea of. All of these concepts dictate the way business is run and ensure your success as a new small business. While all other concepts have their importance as well, the financial concepts required for running a business are important for your success. We realize how a poor grasp on financial concepts governing business can impact your profitability and growth. Within financial concepts as well, some are extremely important while others that don’t hold much value. One such concept that is extremely important to the success of your business is liquidity, and here we will be discussing everything you need to know about liquidity inside your business.
Evaluating investments and calculating your financial position is an important part of running a business. You need to realize that your business can only work if you keep appraising your investment and keep making sure that the business is on track towards success. Regardless of whether you are evaluating your investments or finding out the current financial standing of your business, the liquidity ratio should be your go-to option for all these actions.
To know the importance of liquidity as a concept, you need to first study its definition and understand what it is. We see entrepreneurs and small business owners throw around this word randomly without having the actual context to the importance that liquidity holds. Is liquidity all that important as it has been made out to be? Or is it just another catchphrase that has been running rounds across the world of businesses for way too long now? Let’s find out.
What Is Liquidity?
For those who aren’t yet aware of it, liquidity refers to your ability to convert any of your assets to cash, while maintaining its value. Liquidity is important for the wellbeing of your business, as it dictates the ability of the business to finance itself in the event of a cash crunch.
Your business is a separate entity, and when faced by bankruptcy, it should be able to pay its dues in the best manner possible. Liquidity refers to the ability of your business to pay off existing obligations without depleting your cash reserves. All companies tend to have some liquid assets that can quickly be sold for cash to pay off their debtors.
The liquidity of all assets is solely focused on how quickly an asset can be converted into cash that is of equal or greater value. All assets that take longer when you try to sell them, or won’t sell off at their net book value are known to be less liquid in respect to other assets.
We understand that you will only be able to comprehend these concepts through the presence of real-life examples and assets. Here we list down all of the real-life assets you might encounter during your time in business, and how liquid they can be in the long run.
Hard cash is the first on our list and is also perhaps one of the most liquid assets around. Hard cash does not require any hassle when you are converting it and would maintain its value perfectly well. The cash you have within your business would most definitely hold its value in times of bankruptcy and will be used whenever you want to use it.
An example of cash within your business can be the cash you hold or the cash that you have invested in a savings account. Well, sure enough, the cash in the savings account might not be accessible to you immediately, but you surely can get it in your hands during the times of bankruptcy. Cash neither depreciates nor loses its value. You will be able to use your cash at the value that you have listed in your books. This is why cash is known to be one of the most liquid assets around.
Consider you have over $8,000 in cash within your business. This cash would retain its value in an emergency and allow you to cover for losses that are within $8,000.
Securities are all assets held by a business in the form of investments. Securities include assets like bonds, treasury notes, and stocks. All securities that you hold can easily be converted into cash when the time comes, and are second only to cash when it comes to liquidity.
Businesses often own securities for this very reason. Not only can securities appraise the value of the investment over time, but they are also a good way to invest idle cash. Once a cash crunch strikes, they can always sell off these securities for the best results possible.
Your accounts receivable happen to be all of your customers that you have sold goods to at a discount. Credit customers are part and parcel of every business, and they often make up the highest percentage of your sales. Just how you purchase goods at credit, you also will be required to sell them off on credit.
Now, the goods you sell on credit would be paid for at one time or the other. You need to realize that all debtors who owe you money will eventually pay it back. Well, there are some bad debts, but it is mostly smooth sailing if your debt collection methods are flawless.
In the case of a cash crunch, you can always go to these debtors and ask for the due payment. Account receivables thus happen to be a liquid asset as well.
Your inventory is all the stock that you have on hand for selling to your customers. Inventory is considered by many to be a little less liquid than the other current assets on this list. The thing about inventory is that it might take you some time to sell it. Inventory is stored at the value that you purchased it at, which is why you can extract revenue as well while selling it off.
While inventory is considered to be mostly liquid, experts suggest that you shouldn’t treat it as a liquid asset, because you’re not sure how long it will take you to sell your goods at the time of a financial crunch.
Inventory can get stuck with you at times, without any plausible option available for you to sell it off.
Fixed assets are all of your long term assets that will be in your control for a longer period. Fixed assets happen to be mostly unique and are considered to be illiquid or not liquid at all. All of your long term assets including your real estate and your vehicle will take some time selling. Even if you try to sell them off at a hurry, you will have to accept a lower value for them. The concept of liquidity as we all know by now is all about selling your assets of quickly at an equal value.
As we can relate to from all of our day-to-day dealings, fixed assets cannot be traded off as fast as you want. Such assets take some time while being traded off, and if you try to speed up the process, you will have to incur losses.
What Can You Do to Improve Liquidity?
Knowing all about liquidity now, and the liquidity associated with different assets, you would now want to know all you can do to increase the liquidity of your business.
Repeating what we have talked about in a detailed manner above, the liquidity of your business is the inability to pay loans as they come. Most entrepreneurs and business owners realize that cash is king, which is why they value all the cash that is coming into your business.
When it comes to liquidity inside the business, there are a couple of ratios that can be used for quantifying liquidity and seeing how you stand. You need to know where you stand when it comes to liquidity so that you can take the relevant measures required for improvement. The status of your company can duly be improved if you take liquidity measures right when they matter.
The two ratios used for measuring liquidity in businesses are known as the current ratio and the acid test or quick ratio. The current ratio gives you an understanding of liquidity at face value, while the acid test ratio delves deep down into details and gives you further details. Both of these ratios are geared towards understanding liquidity and working on it.
The current ratio requires you to calculate all of your current assets and all of your current liabilities separately. Your current assets include all assets that have a short life and can be sold for cash while maintaining their value. Cash in bank, securities, account receivables, and inventories fall within current assets. Once you know the total for this, you divide it with the total for current liabilities, which relates to the amount of loan you owe to other people. Once you divide the total for current assets by the total for current liabilities, your answer should come around 1.5 – 2.5. This is a due indication of good liability. Anything below that should ring as a warning bell inside your organization.
The acid test ratio further intensifies this process and takes out inventory from the total for your current assets. Inventory, as we have discussed, is concerned as a liquid asset, but is still less liquid than some of the other assets within current assets. Thus, by reducing the inventory you own, you will be getting a good idea of your liquidity standing. While the current ratio, discussed above, is authentic as well, it can fool a business into thinking they have good liquidity when more than half of their current assets are inventory. Once you subtract the inventory from the current assets, you follow the same procedure and divide the total by the total for current liabilities. The total for current liabilities should remain the same. Once you have done this, the answer should be anywhere around 1.25 – 2. Anything less than the above should signal grave danger for you and should prompt you to immediately start work on your liquidity. Ignoring liquidity with such warning signs can have great consequences.
Knowing the consequences of poor liquidity, here we mention some of the tips you can follow for the best results. Use these tips for managing your liquidity and making sure that your accounts are taken good care of.
Start Sweeping Accounts
Many businesses use sweeping accounts as a genuine way to maintain their liquidity in the long run. Any excess cash that a business has should not just be lying down. It should also not be tied in the form of a useless asset that reduces your liquidity.
Instead of doing any of the above with your excess cash you should make sure that you use your cash for generating some excess cash while maintaining the liquidity of your business.
By sweeping accounts, we mean that you should transfer your cash funds to an interest-bearing account in the bank when you don’t need that cash. But, as soon as you need the cash for your operations, you should transfer it back into your original account. This will surely give its due dividend and will make sure that your business has a good liquidity status at all times.
Reducing costs almost always has a direct impact on both liquidity and profitability. The progress of your business is dependent on how well you manage costs and improve your profitability and liquidity through this procedure. Your inability to manage your costs in the best manner possible would lead to different consequences including decreased profitability and decreased liquidity.
The best way to progress here is to keep a stringent eye on the costs that you bear in a specific period. Some of the tips you can follow for cost reduction here include:
- Remain frugal with all of your expenses, especially those incurred towards energy costs. Energy costs such as heating and lighting can hit your wallet hard, which is why we suggest taking preemptive measures in time. You should have due checks on energy consumption inside the corporate office and manufacturing plant, to make sure that the bills don’t exceed your paying capacity.
- We see that most new businesses hire more labor than what they require. Regardless of whether you are a small business, a startup or a well-established brand, you should make sure that you hire only as many people as you require. If you think that you don’t need extra staffing for telemarketing procedures, don’t go for it.
- Most businesses often end up renting out or buying more space than that is required by them. Renting out more space can have deadly consequences, which is why we suggest renting the space you desperately need for your operations. Renting out or buying more space can eventually increase daily operational costs incurred towards cleaning and maintenance as well.
Keeping a check on your expenses would reduce the operational costs and would make sure that you’re able to achieve success in a manner that you’re capable of.
Monitor Accounts Receivables
As we have discussed above, account receivables happen to be customers that you deal with on a credit basis. These are trusted customers that you sell goods to on credit, and who pay you after a specific period. The sales you make to these customers are recorded in your revenue and profit, but they aren’t yet recorded in your cash and bank reserves, because the payment hasn’t been made yet.
Thus, if you want to manage your small business liquidity in the best manner possible, then you have to keep a stringent eye on your account receivables. You should make sure that your accounts receivables are being duly managed and that you follow the right procedures for receiving prompt payments.
Don’t let your debtors slack on you, as that will lead to more bad debts than you first expected. The best way to handle your debtors is to keep sending them invoices and receipts and to make sure that you manage the due payment plans at the start of the procedure, and make sure that it is adhered to.
Most small businesses get excited at the idea of revenue generation and forget all that they should not about debt collection. Do not neglect the importance of drafting a proper payment plan at the time of the sale.
Reduce Owner Drawings
As we have mentioned multiple times in our blogs, owners need to be careful about the money they draw at the start of business. Owners should set a fixed salary for themselves and should ensure that they follow that amount to the Tee and don’t make any other withdrawals.
Most small businesses fail to grow big, because the owners monitoring them keep taking out money from the business accounts, without recording it in the statements. All of the cash you have in the business today has a due role to play, which is why you should make sure that your cash reserves are safeguarded with the due care that is required.
Owners also should remain frugal at the start and should try to minimize expenses as much as they can. Additionally, as a business owner, you need to make sure that your cash reserves are allowed to build with time and that you don’t mix your finances or credit with that of the business. Treat the business as a separate legal entity.
Monitor Accounts Payable
You also need to monitor your accounts payable in a better manner so that more manageable payment terms are reached with your lenders. You can bargain payment terms with your creditors, to make sure that the terms are manageable for you and don’t severely hit your liquidity.
Also, make sure that you buy from trusted venders and only sell to trusted customers. Dealing with customers and suppliers that aren’t trusted can damage your liquidity and payment plans.
Get a Small Business Loan
There are times when a liquidity crunch is manageable, and then there are times when a liquidity crunch is just out of your hands. If you don’t take the right measures to manage liquidity, it can soon reach a point of no return. This is when you have to check your options and go for external help from external lenders.
While many might think of banks as the sole option here, there are numerous other private lenders as well, that can make the loan process a lot easier for you.
Based on the concepts that we discussed above, you might wonder that taking a small business loan will further reduce the score you get through the current and acid test ratio. But, the fact of the matter remains that cash generates cash. There is a reason why cash is known as the king in business because only it can generate more profits or cash.
The profits you gain cannot be actualized the way you want, but cash can. So, once you face a liquidity crunch, you need to inject some life in your business through a small business loan. A small business loan or a merchant cash advance will allow you to increase your working capital and eventually generate more profits. These profits can further be used for improving the liquidity status of your business in the long run.
Thus, taking external help can improve your small business towards generating the desired results and improving liquidity.
With all this information on liquidity, you need to be extremely careful while running your business, to make sure a liquidity crunch is never reached.
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