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How much liquidity does my business need?

You know that saying money makes the world go ‘round? It may not be entirely true, but if you’re a business owner, you’ll most likely be able to relate. Maintaining a healthy cash flow in business is what enables you to keep the business moving along smoothly. Liquidity is a crucial part of cash flow, as enterprises need liquid assets to operate on a day-to-day basis and manage any unforeseen circumstances.

It’s not hard to fall into the trap of confusing profitability for liquidity. Still, profits from sales do not necessarily equate to business cash flow — especially if profit-making is postponed due to delayed transactions and unpaid invoices. This is why it's vital to focus on having good business liquidity.

What is liquidity in a business?

Financial liquidity refers to how easily assets can be converted to cash. A business is said to have a high level of liquidity when it has liquid assets that can easily be converted into cash in a short amount of time.

Assets with short turnarounds for liquidity - sometimes referred to as quick assets - include cash, savings accounts, term deposits and even accounts receivable if you are sure they will be paid soon. Other assets, such as equipment, land and property, are less liquid, as selling these to obtain cash may take weeks, if not months. 

Advantages of High Liquidity 

  • Survive emergencies and down-economies

If 2020 has taught us anything, it’s that you can never be sure about potential disasters that could be lurking around the corner for your business. High liquidity and cash flow act as a buffer to continue meeting your obligations — such as rent, wages, and bills — in the face of unforeseen events such as less demand for your goods or services, the loss of key customers, and even global pandemics! A solid operating cash flow ratio may mean that you’re in a good position to manage obstacles as they come up and be in a position to take advantage of opportunities to grow your business. 

  •  Meet your liabilities when they are due and access early payment discounts

Having to pay a late fee on a bill because you didn’t have the cash available to pay before it was due is a really great way to waste a lot of money. In addition to avoiding late fees, some suppliers offer early payment discounts, so if you have the cash lying around, you might be able to take advantage of some valuable discounts. To figure out if the discount is worth parting with your money early, calculate the percentage of the discount. For example, if you are getting $200 off a $2,000 bill by paying early, you’ve scored a discount of 10%. And then compare that rate to the rate of the return you would earn on the money if you were to hold onto the cash for longer. In a lot of cases, you’ll be saving more money than you’d earn on the cash, so it could make sense to pay your bills early. 

  • Avoid paying high-interest rates on debt

Having cash on hand can mean that you avoid having to take out expensive business loans at short notice. While debt can be a good way to achieve business growth, sometimes it is an unnecessary expense that cash flow management could have helped avoid. Having to take out loans more often than necessary can quickly become expensive, overwhelming and stressful — and if the business is relatively new, it may not even qualify for debt, so liquidity could be the thing that keeps a young business operating. Keeping cash on hand can provide significant peace of mind to business owners and can help to save money.

Disadvantages of High Liquidity 

  •  Opportunity Cost

Doing one thing with your money always means you’re having to make a choice and forgoing spending it elsewhere. While you are holding cash for a rainy day, you miss out on other opportunities, such as investing in new equipment or other assets that could provide a higher return on the investment. It’s all about risk management, though. So just because you could be earning a higher rate of return doesn’t mean that you should do it. Weigh up your risk factors and decide on what level of liquidity is right for your business.

  • Falling behind your competitors

Research and development are paramount in many industries to gain and retain market share. If you are holding your money to keep liquidity high, you could be falling behind your competitors in terms of upgrading your offering to consumers. When cash flow is tight, it’s important to be mindful of where you are spending your money. If you can’t keep up with your competitors, it might be time to look at other forms of finance to keep you ahead of the game.

  •  Higher Tax Bill

If your liquid assets are earning income — such as an interest-bearing savings account — you may need to pay tax on the returns. This is in stark contrast to using debt such as business loans because you’ll usually be able to claim a tax deduction on the interest expense. Liquid assets could increase your tax bill, while debt can reduce your business tax bill. While minimising tax is often important to business owners, it’s essential to look at your finance and business needs on a holistic level and not just about trying to reduce your tax liability. 

Find what works for your business

There’s no right or wrong answer when it comes to deciding how much business liquidity to have. There are ratios to use that help give a general idea of how likely you’ll be able to meet your liabilities, but it really comes down to your individual needs. While using cash on hand to buy supplies in bulk might be a great way to save money, you’ve just turned a liquid asset (cash) into a non-liquid asset (supplies) and if your business is experiencing a lot of uncertainty, maybe that's better left in cash until the future looks clearer? All businesses face different circumstances and therefore have different liquidity requirements, so you need to do what's best for you and your business.

How to calculate your liquidity

A business can measure its liquidity by using the current ratio (or working capital ratio), in which it divides its current assets by its current liabilities. Not only does this ratio measure a company’s liquidity, but it may also help business owners to identify their company’s ability to meet short term debt obligations and expenses. 

The quick asset ratio is a stricter measure of liquidity as it excludes inventory which, although it is a current asset, cannot always be turned into cash quickly. Depending on your industry, it's likely that there is at least some of your inventory that is obsolete and will never lead to sales, and if it does, it may not be for a long time. As a general rule of thumb, if your 'quick assets' comfortably cover your current liabilities, you are holding a decent level of liquidity.

Cash flow and liquidity often go hand in hand when it comes to assessing a business’s financial health. Another helpful formula — the operating cash flow ratio — can help a business owner effectively measure short-term liquidity. 

The operating cash flow ratio calculates the number of times a business can pay off its liabilities with cash generated in a set period. The ratio is found by dividing the operating cash flow by the current liabilities. A higher ratio indicates a business can cover its liabilities a greater number of times. And if this number trends higher over a while, it may dictate a level of good financial health in the short term.

The formula looks like this: Operating Cash Flow Ratio - Cash Flow from Operations / Current Liabilities

Having high liquidity is an indicator of a strong and healthy business. But it’s worth keeping in mind that business liquidity levels may also indicate a lack of risk-taking due to the company not investing as much as it should or could. Take stock of your liquidity frequently so you may be able to identify the best strategy for your business to continue to grow. And remember, there are flexible finance options available such as a business line of credit that let's you access cash when you need it without having to draw the full amount.

If your business needs any help with working capital management via a business line of credit, accounts receivable financing, equipment financing, or trade financing, contact Earlypay’s helpful team today on 1300 760 205 or visit our sign-up form.

 


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