What is liquidity in business? A guide for small businesses

Liquidity is a company’s ability to cover its short-term expenses with its current available assets.

It plays a crucial role in the success of a business.

If you don’t have enough money to cover your costs, you might struggle financially, and your venture could fail.

What is business liquidity?

Liquidity is defined as a business’s ability to pay its bills and make loan repayments in the short term with its ‘liquid’ assets.

These assets include cash and those that can be turned into cash without losing value, such as inventory (goods or materials on hand), equipment, and certain investments.

Liquidity is sometimes confused with cash flow.

Although the terms are closely related, they are different things.

Cash flow is the money flowing in and out of a business during a specific period, whereas liquidity is the ability of a company to meet its financial obligations in the short term.

Liquidity is also different to working capital, which is the money that remains after a business (its current assets) has settled its bills.

The importance of business liquidity

Liquidity is an important issue that entrepreneurs need to be aware of.

If your business has low liquidity and can’t quickly generate cash from its assets when needed unexpectedly, you could face difficulties settling essential bills such as staff wages and paying suppliers.

In the worst-case scenario, low liquidity leads to a business becoming insolvent or bankrupt.

Having high liquidity can help your business grow and attract investment.

Financial lenders and investors usually check a company’s liquidity before providing funding.

High liquidity also means you can better adapt to surprise financial challenges or an economic downturn.

Interestingly, high liquidity isn’t always a good thing.

It could mean that you aren’t properly managing your finances by not fully using your resources, such as investing in new equipment or improving processes, which could hinder your business’s growth.

How to work out the liquidity of your business

Liquidity is calculated as a ratio that measures the gap between your business’s current liabilities (debts and financial obligations) and current assets.

There are various ways to work it out:

Cash ratio

This is calculated by dividing your cash and cash equivalents by your current liabilities.

This financial metric measures a company’s ability to immediately pay off its current liabilities using only its cash and cash equivalents (short-term investments that can easily be converted into cash) – rather than having to sell assets to generate cash.

Cash + Cash equivalents ÷ Current liabilities = Liquidity ratio

Quick ratio (also known as the ‘acid test’)

This method excludes your inventory.

Current assets - Inventory ÷ Current liabilities = Quick ratio

Current ratio

This calculation takes into account all of your current assets.

All current assets ÷ Current liabilities = Current ratio

A ratio of one or above typically indicates that a business has ‘good’ liquidity and will be able to fulfil its liabilities over the next 12 months.

A ratio below one suggests low liquidity and the business faces a financial risk because it doesn’t have enough assets to cover all bills.

The importance of business liquidity planning

Liquidity planning involves keeping track of your business’s liquidity to ensure that you are able to cover planned and unexpected financial business expenses.

Here are some tips:

Be aware of all your business income

You need to fully understand all of your company’s sources of income to maximise your liquidity and ensure you have adequate funds to cover all of your expenses.

Understand your expenses

Be aware of how much money your business is spending and manage having cash tied up in non-productive ways.

Creating a budget and cash flow forecast will help you do that.

You can then identify which assets you can retain and invest and which you might need to cover expenses.

Know the liquidity value of all your assets

Understand the ease, speed, and process of liquidating each of your start-up’s assets, so you know how quickly you can generate cash from the asset to cover an expense.

Categorise your liquidity

You can effectively monitor your liquidity by dividing it into three categories – this will help you plan financially for every situation.

The categories are:

• essential liquidity – your essential day-to-day expenses that ensure your business keeps trading, such as rent, mortgages, and staff wages
• precautionary liquidity – the easily accessible cash your business has to cover unexpected and emergency expenses
• discretionary liquidity – these are the assets you have available to take advantage of important business opportunities such as investments, purchasing another business, or buying a property.

Improving liquidity in business

You can improve liquidity in the following ways:

Reduce costs

Regularly review your business costs to discover where you can make reductions to improve your liquidity ratio, such as:

• cancelling unnecessary subscriptions
• reducing energy usage to cut bills
• negotiating better deals with suppliers
• moving to a cheaper office or switch to working from home

Read more guidance on cutting business costs.

Settle your debts

Pay off liabilities such as loans, taxes, bank fees, and interest to boost your liquidity.

Chase and prevent late payments

Customer’s failure to pay invoices on time can reduce your liquidity, so make sure you chase them for overdue payments.

You can also take steps to prevent future late payments, such as:

• carrying out credit checks of potential customers
• negotiating better payment terms with customers
• automating invoicing and follow up
• building stronger relationships with clients.

Find more tips on tackling late payments.

Take on longer-term finance

Short-term financing can negatively affect your start-up’s liquidity due to high interest rates. Look for longer-term funding options or refinance short-term loans to get more favourable interest rates.