Part of being an effective leader of your small business is to be able to make sense of the numbers and to know that cash is king! Understanding liquidity is important because your business must be able to understand how to properly manage liquidity in order for your business to expand and grow.
As a small business owner, liquidity should not be underestimated in its importance for enabling your small business to survive seasons when cashflow shrinks or when expenses increase. A business can have plenty of assets; however, if these assets cannot be easily turned into cash when your company needs the cash, then the assets are essentially of no value to helping your business through its cash flow needs.
The closer an asset is to being turned into cash the more liquid it is. When looking at your company’s liquidity, it is important to compare apples to apples. As an example, compare short term obligations to short term assets and so on. Also, it is important to remember that any balance sheet analysis reflects only a single point in time and not the future so it is important to be able to competently forecast as well.
Some factors to consider when calculating liquidity are current assets, prepaid expenses, and short term liabilities.
- Quick assets refer to assets owned by a company with a commercial or exchange value that can easily be converted into cash or that is already in a cash form. Quick assets are the highly liquid assets held by a company, including marketable securities and accounts receivable. Companies use quick assets to calculate certain financial ratios that are used in decision making, including the quick ratio.
- Current Assets – These are a type of Quick Asset which are accounts on a balance sheet which represent the value of all assets which can reasonably be converted into cash with one year. In other words, they are fairly liquid. Some types of current assets include cash and cash equivalents such as bank accounts, marketable securities, commercial paper, Treasury bills and short-term government bonds. Additional types of current assets include accounts receivable, inventory, and prepaid expenses.
- Prepaid Expenses – Prepaid expenses are slightly different as you have already paid out the cash. An example is prepaid office rent.
- Short Term Liabilities – Short term liabilities are obligations that require cash payment within a year. These might include bank lines of credit and other debt due within one year. It also includes accounts payable to suppliers, taxes payable to governments, etc. Anything where you need to make a cash payment within a year would be a short term, or current, liability.
Liquidity ratios are how your small business demonstrates its ability to repay debt. Here are some liquidity ratios:
- The current ratio is a liquidity ratio that measures a company’s ability to pay short-term and long-term obligations. To gauge this ability, the current ratio considers the current total assets of a company (both liquid and illiquid) relative to that company’s current total liabilities. The formula for calculating a company’s current ratio, then, is: Current Ratio = Current Assets / Current Liabilities
- The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets. For this reason, the ratio excludes inventories from current assets, and is calculated as follows: Quick ratio = (current assets – inventories) / current liabilities, or = (cash and equivalents + marketable securities + accounts receivable) / current liabilities. The quick ratio measures the dollar amount of liquid assets available for each dollar of current liabilities. Thus, a quick ratio of 1.5 means that a company has $1.50 of liquid assets available to cover each $1 of current liabilities. The higher the quick ratio, the better the company’s liquidity position. Also known as the “acid-test ratio” or “quick assets ratio.”
- Quick Liquidity Ratio – The total amount of a company’s quick assets divided by the sum of its net liabilities and its reinsurance liabilities. Quick assets are liquid assets such as cash, short-term investments, equities, and corporate and government bonds nearing maturity. The quick liquidity ratio shows the amount of liquid assets an insurance company can tap into on short notice.
- The quick liquidity ratio is an important measure of an insurance company’s ability to cover its liabilities with relatively liquid assets. A company with a low quick liquidity ratio that finds itself with a sudden increase in liabilities may have to sell off long-term assets or borrow money in order to cover its liabilities. For example, an insurance company may find itself with a sudden increase in liabilities if a hurricane causes significant damage to its policy holders.
As an entrepreneur, if you need more help with understanding your company’s liquidity, we are happy to help you with this.