Every business has bills to pay. Your ability to pay them is called “liquidity,” and it’s one of the major vital signs that accountants and investors look for in the financial health of a business.
In this guide we’ll go over exactly what liquidity is, how to measure it, and what to do when it’s running low.
What is liquidity?
Liquidity measures how capable your business is of paying its bills. If you have liquidity, that means you don’t have to do anything drastic to settle your debts, like sell your car or declare bankruptcy.
Put in accounting speak, liquidity measures how capable your business is of settling its current liabilities using cash or any other current assets it owns.
What are current liabilities?
These are any outstanding bill payments, payables, taxes, short-term loans or any other kind of short-term liability that your business must pay back within the next 12 months.
What are current assets?
Current assets are cash or any other kind of asset that can quickly be converted to cash. For our purposes, we’ll be dealing with four kinds of current asset in this guide:
This category includes cash and short-term securities that your business can quickly sell off and convert into cash, like treasury bills, short-term government bonds and money market funds.
Marketable securities typically have a maturity period of one year or less, are bought and sold on a public stock exchange, and can usually be sold within three months on the market. Examples of marketable securities include common stock, treasury bills and commercial paper.
Accounts receivable is money your customers owe you for any products or services you delivered and invoiced them for. Receivable are considered to be a “liquid” asset because companies can usually depend on collecting most of them within a few months.
Inventory is all the goods and materials a business has stored away for future use, like raw materials, unfinished parts, and unsold stock on shelves. Of the four current asset types, it’s the least liquid, because it’s the hardest to turn into cash.
How do I measure liquidity?
There are three main ways to measure liquidity: the current ratio, the acid test ratio, and the cash ratio.
Using the current ratio
The current ratio (also known as the working capital ratio) is one of the most popular methods of figuring out how liquid a business is. It shows how many times a business can pay off its current liabilities using its current assets.
Here’s the current ratio formula:
Current ratio = current assets / current liabilities
The current ratio is the easiest way to measure liquidity.
Let’s say, for example, that a company’s current assets total $25,000, and it has $32,000 in current liabilities.
That means its current ratio is:
Current ratio = $25,000 / $32,000 = 0.78125
In theory, a company with a current ratio of less than one doesn’t have enough current assets to cover its current liabilities, and might have liquidity problems. But in practice that isn’t always the case.
For example, a low current ratio could simply mean that a company is very good at keeping inventory low. (Remember: inventory is included in current assets.)
A company with a low current ratio could also simply belong to an industry where it’s normal for companies to collect payments from customers quickly, but take a long time to pay their suppliers. A few examples: retail, and restaurants, where the average current ratio tends to be below 1.00.
Using the acid test ratio
The acid test ratio (also known as the quick ratio) is like the current ratio, but a bit more conservative.
Instead of dividing total current assets by total current liabilities, the acid test ratio leaves inventory out and keeps the three other major types of current assets: cash equivalents, marketable securities and accounts receivable.
Acid test ratio = (cash equivalents + marketable securities + accounts receivable) / current liabilities
Because inventory levels vary a lot across industries, this ratio should in theory give us a “purer” reading of a company’s liquidity than the current ratio. But just like we did with the current ratio, it’s important to read the acid test ratio in context.
An acid test ratio below one could mean that you’re having liquidity problems, but it could just as easily mean that you’re good at collecting accounts receivable quickly. Similarly, an acid test ratio greater than one doesn’t automatically mean you’re liquid, especially if you run into any unexpected problems collecting accounts receivable.
Using the cash ratio
An even more conservative liquidity test is the cash ratio. This one takes accounts receivable out of the equation, leaving you with only cash equivalents and marketable securities to cover your current liabilities:
Cash ratio = (cash equivalents + marketable securities) / current liabilities
If you have a high cash ratio, you’re sitting pretty. It’s the most conservative measure of liquidity, and therefore the most reliable, industry-neutral method of calculating it.
What is liquidity risk?
Waiting on too many payments from your clients? Don’t have enough money to pay your bills? You might have too much of what accountants call liquidity risk.
Businesses with high liquidity risk are at risk of not being able cover their short-term bills and liabilities. The end result of too much liquidity risk is insolvency, which happens when a company is completely incapable of paying its debts and must restructure, sell its assets, file for bankruptcy, or go out of business.
Companies usually develop liquidity risk when they’re not carefully managing cash flow, not selling enough inventory, or depending too much on loans to grow their business.
How is liquidity different from solvency?
Solvency and liquidity are similar, except for one important factor: solvency has more to do with a company’s ability to pay all of its debts, while liquidity has more to do with a company’s current debts.
A company that doesn’t have many current assets but lots of long-term assets could potentially be illiquid while still being solvent.
You can think of solvency as a kind of “long-term liquidity”, while what we’re discussing in this guide is short term liquidity.
How do I increase liquidity?
A company with low liquidity risk is a healthy company. But how do you actually become more liquid? Here are some steps you can take:
Cash is the most liquid asset there is. The more you earn, the more liquid you’ll be, and one of the simplest ways to do that is to drum up more business.
The better you are at marketing, selling and turning that unsold inventory (not very liquid) into cash (very liquid), the more liquid your business will be as a whole.
Even if you don’t have inventory, this still applies. The more revenue you have, the more likely you’ll be able to pay your bills. “Sell more” might sound painfully obvious, but when a liquidity crisis is looming, it’s nice to have all your options clearly on the table.
Spiralling overhead costs can be a huge drain on your business’ cash reserves. The more you can do to reduce them—by cutting down on non-essential spending, negotiating better deals with your suppliers, and conservative budgeting—the better prepared your business will be to cover its short-term liabilities.
Further reading: The Small Business Owner’s Guide to Cutting Costs
Get better at collecting invoices
The better you are at turning receivables into cash, the more liquid you’ll be. You can do this by:
Shortening the time it takes to collect payments from your customers
Making payment terms more explicit
Instituting late payment penalties
Further reading: How to Set Up (And Optimize) Your Accounts Receivable Process
Pay off your debts faster
Another way to increase liquidity is to cut down on sources of illiquidity in your business—your debts. The more short-term IOUs you can avoid with your suppliers and lenders, and the more current liabilities you can pay down today, the lower your liquidity risk.
Further reading: How to Pay off Your Business Debt, Fast
Sell your assets
It’s not a long-term fix, but selling unused assets can be a quick way to generate cash and increase liquidity. Just make sure the assets you’re selling won’t hurt you in the long run (like selling a piece of equipment you’re going to need again in 12 months).
Refinance your debt
Liquidity is about current liabilities, not long-term ones. If you can swing it with your lender, one way to get around the problem is to kick the can down the road and turn your current liabilities into long-term debt through refinancing.