What is liquidity?
In simple words, liquidity is how much cash you have on hand, and the ease of converting other assets you may have, into cash. Depending on the market and the nature of the asset, we can determine a different level of liquidity for each asset. What do you think is the most liquid asset in the economy? What can be converted to cash at ease? The most liquid asset in the word is… cash.
Simple, right? And next to cash, we can convert money in the bank to cash quite easily.
However, an asset like a piece of land is comparatively difficult to convert into money, right? We would have to advertise, convince buyers and sometimes even hire brokers. How about an antique you inherited? How hard would it be to sell it and convert to cash? Well, the answer would be pretty hard. Likewise, different assets have varying degrees of liquidity.
Why is liquidity important?
Well, you must always keep in mind that it is vital to maintain sufficient liquidity within your business to handle all the expenses from daily operations and emergencies. Imagine yourself in this situation: You have spent all of your liquid cash and bought machinery for your business. What are you going to do until or unless more cash is received from operations? How are you going to handle your daily expenses? Employee wages? Therefore, it is important to maintain a proper liquidity balance in your business.
How do you decide on the degree of liquidity?
What can you do with having only liquid cash in your business? You will need some assets as well, otherwise what kind of a business are you running? How do we determine the optimum liquidity for a business? Liquidity ratios come in handy for this purpose. With the aid of these ratios, you will be able to identify if your business is sustainable in terms of liquidity. These ratios include;
- Current Ratio
- Quick Ratio
- Operating Cash Flow Ratio
The current ratio is the ratio between the current assets of the company in relation to the current liabilities. That is,
Current Ratio = Current Assets / Current Liabilities
This ratio measures if your business is able to pay off all short term liabilities (due within a year) using the Current Assets you have on hand. Investopedia defines current assets as all the assets of a company that are expected to be conveniently sold, consumed, utilized or exhausted through the standard business operations, which can lead to their conversion to a cash value over the next one year period and current liabilities as a company’s short-term financial obligations that are due within one year or within a normal operating cycle. If the ratio is more than 1, it is considered as a good liquidity level. However, we need to compare the current ratio levels of businesses in the industry with ours in order to get a proper understanding.
The next liquidity ratio is the Quick Ratio. The Quick Ratio, also called the Acid Test Ratio, measures the short term liquidity position of an organization. The Quick Ratio measures the ratio between your cash and cash equivalents against current liabilities.
Quick Ratio = Cash and Equivalents + Marketable Securities + Accounts Receivables / Current Liabilities
If you are confused as to what these elements mean, go ahead and give it a simple online search. Here as well, a ratio above 1 is considered an optimum liquidity level.
Now, the last ratio for we will discuss is the Operating Cash Flow Ratio. The name is pretty much self-explanatory. This ratio explains how well the current liabilities of the business can be managed using only the operating cash flows of the business.
Operating Cash Flow Ratio = Operating Cash Flow / Current Liabilities
In this case as well, a ratio above one is considered optimum. Now, when we consider all three of these liquidity measures what we are trying to measure is the efficiency of how we can settle our liabilities using our assets. Hence, maintaining excess liquidity does your business no favours, as cash in its cash form will not generate any interest or income. Therefore, you always need to invest cash in assets or income-generating activities without letting cash lie around for the sake of liquidity. Practice and learn the art of liquidity management. You won’t regret it!