Liquidity for a small business means the ability to cover its short-term financial obligations. It refers to the ease with which the assets can be converted to cash.
By calculating and tracking different ratios of your company’s assets and liabilities, you can measure your business’ liquidity. This is necessary for spotting cash flow problems and checking if your business is in good financial health.
What this article covers:
What Is Liquidity in Accounting?
What Is Liquidity Ratio?
Why Is Liquidity Important?
How Can Liquidity Be Improved?
In accounting, liquidity is the ability of the current assets to meet the current liabilities. It is the number of liquid assets of a business that can be traded in the market without losing its value. The current assets can be turned into cash within a year and are available to pay short-term expenses and debts.
Since it can be used to pay off debts and make purchases quickly and easily, cash is considered the standard measure of liquidity. The other current assets are listed in the order of liquidity, which is the order in which they are expected to turn into cash.
Assets such as stocks are easily converted into cash and they are higher up in the order of liquidity. Other liquid assets include saving accounts, accounts receivable, time deposits, mutual funds, U.S. Treasuries and bonds.
The current ratio, also known as the working capital ratio, is calculated by dividing the current assets (cash, temporary investments and accounts receivable) of a business by its current liabilities.
These are the short-term assets and liabilities that are consumed and paid off in less than a year. It gauges the business’ ability to pay back its short-term liabilities with short-term assets. If you have a current ratio of 2:1, you have a financially healthy business.
Also known as the acid test ratio, it measures the company’s ability to meet its liabilities with only quick assets such as cash, cash equivalent, short-term investments and current receivables. This ratio does not take into account current assets like prepaid expenses and inventory.
Liquidity means accessible funds. As a small business owner, you know how crucial it is to maintain the cash flow in the business. In fact, it is the single most element of survival for small businesses and start-ups.
Most business owners mistake profits for liquidity. The difference between the two is the time. When you sell a product, you make a profit but that does not equate to cash flow as money takes time to reach your account. Which is why you need to focus on liquidity and managing your cash flow.