What Is Liquidity In Business?

Image of man pressing asset and sell buttons for the What Is Liquidity In Business? blog post by Brixx

Liquidity in business may sound like a complicated concept. However, simply put, liquidity refers to emergency funds, cash on hand, etc. It is basically any form of “cash” that you have access to immediately in the event of unforeseen expenses or financial setbacks. It also allows you to seize opportunities that may come up suddenly that require immediate funding. 

Liquidity comes in two basic forms: market liquidity and accounting liquidity. It should be noted, however, that liquidity and profitability are not the same things as liquidity refers to the ease or efficiency with which an asset can be converted into ready cash without impacting its market price. 

Let’s talk about liquidity in business:

  • What are the types of liquidity?
  • Why plan for liquidity?
  • How can you measure liquidity?
  • What is a liquidity gap?
  • Liquidity planning requires knowing your company’s financial status

What are the types of liquidity?

Market liquidity

Market liquidity refers to investments and assets and how quickly these can be turned into cash. High market liquidity means a high supply and demand for an asset, meaning there will always be sellers and buyers for that asset. On the other hand, if there is nobody to buy the asset then it cannot be liquid as there will not be a transaction to turn the asset into cash.  

For example, we can say that market liquidity refers to a country’s stock market or a city’s housing market that allows assets to be bought and sold at stable, clear prices.

Accounting liquidity

Accounting liquidity refers to personal or corporate finances. Generally speaking, in terms of a company, accounting liquidity refers to the company’s current assets versus its liabilities. 

For example, it can refer to the ease with which a company can pay off its debts or attend to short-term financial obligations. 

Why plan for liquidity?

Liquidity is important to companies as it allows them to meet their debt obligations even if they may have a shortfall in cash. By liquidating assets, companies can utilise these funds to cover whatever gaps may be present in their finances until they get back on track.

Because liquidity focuses on avoiding last-minute liquidity deficits and surpluses within your business, it can ensure that short-term obligations can be met while not holding too much cash on hand either.  

Generally, when planning for liquidity, one can use integrated liquidity planning or predictive cash forecasting.

Integrated liquidity planning

Integrated liquidity planning begins with anticipated liquidity-pertinent events. These would be based on the control predictive cash forecasting stage of the managing. In more simple terms, controllers would provide projections and assumptions derived from control processes, such as anticipated future growth. 

This planning method uses the direct approach methodology while focusing on minimising mistakes from the straight actual cash flows statement (also aiming to eliminate manual planning activities). 

Predictive cash forecasting

Using predictive cash forecasting for liquidity planning is the practice of predicting future values using statistical regression methods to compute a projection of historical data. Unlike other planning techniques, predictive analytics approaches a data-driven analysis of internal and external influences. Here, the cash flow model learns about the various variables and their influences on past cash flows, adjusting its parameters by comparing them to actual data with the least variation between prediction and reality. This allows the model to forecast future cash flows.

How can you measure liquidity?

In order to measure a company’s liquidity, analysts will look at the business’s ability to use its liquid assets to cover its short-term obligations. Generally, when using the analysis formulas, a ratio greater than one is sought.

There are three liquidity ratios are primarily used to measure a company’s accounting liquidity:

  • Current Ratio
  • Quick Ratio
  • Cash Ratio

Ceic Data has an interesting comparison of the liquid asset ratios between different countries as well as key information on the UK’s liquid asset ratios over the years. Here you can see the ratio differences in the UK from 2005 to 2020 and compare that data to the rest of the world. 

Image of person looking over financial data for the What is liquidity in business blog post by Brixx

Measuring liquidity using the Current Ratio

The current ratio measures current assets against current liabilities. Generally referring to any transactions that can be converted within one year.

The formula would be: Current Ratio = Current Assets / Current Liabilities.

Measuring liquidity using the Quick Ratio (Acid-test ratio)

The formula is for this would be: Quick Ratio = (Cash and Cash Equivalents + Short-Term Investments + Accounts Receivable) / Current Liabilities.

Additionally, there is a variation of the Quick/Acid-Test Ratio that simply subtracts inventory from current assets to be more generous. This formula would be: Acid-Test Ratio (Variation) = (Current Assets – Inventories – Prepaid Costs) / Current Liabilities.

The Quick Ratio’s calculation of current assets uses the most liquid assets such as cash, marketable securities, and accounts receivable. However, it does not include inventory, unlike the current ratio.

Measuring liquidity using the Cash Ratio

The Cash Ratio assesses a company’s ability to stay solvent in the case of an emergency in the worst-case scenario. This formula would be: Cash Ratio = Cash and Cash Equivalents / Current Liabilities. This ratio is an even more stringent ratio than the quick ratio as it compares only cash to current liabilities. Therefore, if a company can meet its financial obligations through just cash, it is in an extremely strong financial position.

What is a liquidity gap?

Liquid assets, or “quick assets, ” can easily be converted to cash. These could include cash, marketable securities and accounts receivable from customers. When looking at liabilities, these are obligations a company or individual has the responsibility to repay within one year’s time such as accounts payable, bills, etc.  

The difference between an entity’s total liquid assets and the total amount of liabilities assumed by the company is what we call the liquidity gap. It is a way to quantify an organization’s degree of financial risk. The liquidity gap can be measured in a number of ways, including comparing changes in the gap at multiple points in time. Businesses may also select to assess their financial health by measuring their own liquidity to assess their financial health.

The equation to calculate the liquidity gap includes the total of liquid assets held by the company (such as bank accounts, minus any obligations incurred by them). A negative gap would mean that the company is losing more money than it takes in while a positive gap would mean that it has liquid assets left over after paying off all of its obligations.

Liquidity planning requires knowing your company’s financial status

In order to effectively and accurately plan for liquidity, you need to have an in-depth knowledge of your company’s revenue sources. You will need to be able to create a comprehensive list of any and all income streams to get an accurate look at your current financial state. In order to master liquidity planning, you need to be able to:

  • Understand where every cent is coming from
  • Be aware of how much you spend
  • Define your company’s essential liquidity requirements
  • Create a precautionary liquidity plan
  • Ensure you are aware of how to access your discretionary liquidity
  • Plan for liquidity gaps accurately
  • Balance your liquidity assets allocation with your company’s risk profile
  • Always keep your liquidity plans up to date

We’ve only just touched on the basics of liquidity as a concept in business. While you may think that your company could never hold enough cash, it actually can. As cash itself does not earn anything, holding too much could mean potential losses of earnings. It may be better to invest in assets that allow you to release cash at short notice. It is key to always be mindful of the liquidity position of your business as the closer an asset is to cash, the more ‘liquid’ it is.

Running a successful business means keeping in control of your cash flow. With careful management of your finances, your company can keep in a positive cash flow position and improve the overall liquidity of your capital. Brixx helps startups, established businesses, and advisors keep on top of cash flow while saving hours of valuable time. Offering a free 7-day trial, Brixx can help companies get an accurate view of their finances while exploring multiple scenarios to plan ahead for the future.

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