Liquidity in business has nothing to do with water, milk, or juice! It describes how quickly you can sell an asset and convert it into cash. Cash is the most liquid asset of all. Real estate, in contrast, is not quite as liquid because it could take months to sell it to a new owner.
Liquidity is important to all businesses. It affects your credit score and how much you can borrow. It’s a measure of whether you can pay your bills on time. It’s also one of many measures of the overall financial health of your business.
If your business sells items that take a long time to produce, liquidity can be extremely challenging and should be carefully managed. Examples include farms, wineries, breweries, automobile manufacturers, and biotech researchers.
A couple of financial metrics can quantify your business’s liquidity. The current ratio is computed as follows:
Current Ratio = Current Assets / Current Liabilities
The largest components of current assets include cash, cash equivalents, accounts receivable, and any other asset that is expected to be converted to cash within one year. The largest components of current liabilities include credit card balances, accounts payable, bills due, interest payable, and the amount of any loan due within one year. You can find both current assets and current liabilities on your balance sheet.
Companies with a current ratio of less than 2:1 are considered less liquid, while companies with a current ratio of more than 2:1 are more liquid. However, current ratio values and whether they are “good” or “bad” vary by industry, so before you panic, check out your industry benchmarks.
Another measure of liquidity is the quick ratio. It measures how equipped a business is to meet its short-term obligations by taking its most liquid assets, cash equivalents, and using them to pay down current debt. Its formula is:
Quick Ratio = (Cash + Cash Equivalents + A/R) / Current Liabilities
This ratio’s value should typically be 1:1.
A good common-sense measure you can use to stay on top of your business’s liquidity is to build a healthy emergency fund. To calculate how much you need, determine how much you typically spend each month. You can get that number by reviewing a bank statement and summing all of the withdrawals including checks paid and online withdrawals. Do this for each bank account you have and include other accounts such as PayPal if you use them for disbursements.
This should give you your total spend per month. Go back a few months to calculate an average spend per month. The farther you go back, the more accurate your average will be, especially if you have a lot of large annual payments throughout the year.
Now that you have your average spend per month, your emergency fund should be a multiple of that spend. Three months’ worth should be the minimum amount in your emergency fund. If you spend $50,000 per month on average, your emergency fund should be $150,000 at a minimum.
An emergency fund will not only make your business more liquid; it will protect you if disaster strikes. According to FEMA, 90 percent of small businesses that experience a disaster will fail within a year unless they can resume operations within five days. Having an emergency fund will increase the odds of your business continuing in spite of any hardship that may occur.
If you have questions for us about your business’s liquidity or starting an emergency fund, please feel free to reach out any time.