Liquidity is one of the most important parameters you’ll need to track if you own a business. Making profit doesn’t necessarily amount to much – your company could easily fail if it’s simply illiquid. As a matter of fact, 60% of all companies that ran out of business report that their failure was completely or in large part due to the lack of liquidity.
What is liquidity?
In general, the liquidity of an asset or a security is characterized by how quickly it can be traded in the market without losing its value. This simply means that cash is the most liquid asset – it can be traded for other assets or goods at any moment without its “price” being affected. If you want to go out and buy a car, cash will undoubtedly do the job. On the other hand, if you don’t have cash, but you possess jewelry, expensive Victorian furniture, or a collection of liquor bottles, there’s a good chance you won’t be able to buy a car with it. Rather, you’ll have to sell what you have first, and you’ll need some time to do that – either that, or you’ll need to lower the asking price if you want to get rid of it quickly. That means that jewelry, furniture and strange collections are all relatively illiquid.
For a company, liquidity comes down to their ability to pay off their debts in time which, in turn, usually comes down to how much cash a company has on its hands compared to its liabilities. There are several ways to calculate how liquid your business is – some of them take into account only the amount of cash at your disposal, while some of them include your other assets, or even stocks, bonds and accounts receivable.
Why is liquidity important?
Liquidity is usually compared to your company’s general health – your large profit doesn’t mean much if you can’t pay your current dues and use the money to invest in your business’ development to ensure it keeps rolling. Having a decent amount of cash at any given time also gives you a lot of strategic freedom whenever a good opportunity for an investment arises. Finally, in times of crisis and recession, having cash in your hands is invaluable.
There are two basic ways to raise your company’s liquidity – maximizing cash flow or minimizing liabilities. Let’s first look at a few ways to increase the amount of cash at your disposal.
The first and the most important thing when it comes to keeping your business liquid is not to rely on your instinct but always have a careful calculation as to how your predicted cash earnings compare to your accounts payable. Have in mind at all times that profit doesn’t equal cash. You should try using a cash accounting system, which takes into account only payments made by cash, check or credit card. Furthermore, when making a financial plan for the forthcoming period make sure you include all your future expenses, your taxes and the exact date when they are due. If you can delay a payment for a few days, or speed things up with your debtors, always do it.
Factoring is a very convenient trick when it comes to collecting your money and turning your accounts receivable into cash quickly. A “factor“ – a financing company, offers to cash out your accounts receivable, but for a price. They basically buy your future income, pay up front what your customer is due, and take a percentage, the so-called factoring fee. This is a handy trick if you have a lot of invoices waiting to be paid for, but need the cash straight away. The downside of it is that factor financing is not very well regulated, and factoring firms sometimes lack reliability and integrity.
A simple way to increase the amount of cash flowing through your company is taking a loan. It’s important to choose the right moment and take a loan when your future financial status seems relatively sound, there are a lot of accounts receivable waiting to be settled and you need cash right now to make a smart investment. When this is the case, taking personal loans is a very good trick to instantly improve the liquidity of your business. If you anticipate that taking a loan will help your business in any way – go for it.
Minimize your liabilities
Apart from simply increasing the cash flow, you can also choose the other way – reduce the amount of cash coming out of your company. In this sense, inventory and human resources are typically the biggest drains on your funds. Having too much inventory laying around waiting helplessly to be turned into profit can drastically decrease your liquidity. Make sure you have an effective strategy that will ensure that the big portion of your inventory is always ready to soon be sold and turned into cash.
When it comes to liquidity, be methodical, organized and don’t let yourself get carried away. You need to rely on your cash accounting analysis and behave according to its indicators. It’s important to remember that you shouldn’t get too confident if your profits simply go up – you need to take constant care of how much of the money you earned is actually at your disposal, because without it your business might fail when you least expect it.