We often talk about working capital and sufficient cash flow being two of the most important factors to monitor when running a small to medium enterprise (SME). Without both of these working in your favour, running your business will hit a roadblock – it’s like driving the handbrake on or worse, without enough fuel in the tank. Liquidity is an accounting term that roughly refers to immediate cash on hand, or similar assets, that are available to conduct day-to-day business, such as paying suppliers and employees. You may carry more than enough assets, although if they are unable to be converted to cash in a quick enough time frame, they are not much use in a range of emergency circumstances.
‘Quick’ assets (for example, cash and reliable receivables) are those that support liquidity via providing cash flow when it’s needed. Since cash flow and liquidity is so important, is more always better? Not necessarily. There may be a range of consequences as a result of holding too much cash. The flexibility to scale liquidity up and down when needed is the most critical factor. Let’s take a look at how to measure liquidity in your SME, why carrying more might be a good idea, why it may not be, and how much you really need.
How to Measure Liquidity in Your Business
There are three simple ways to assess the liquidity of your business, although the levels you are comfortable with are unique to your industry and risk tolerance. The primary calculation to undertake is the ‘current ratio’.
Current Ratio = Current Assets
he current ratio is an excellent indicator of how well the business is able to cover its upcoming outgoings. The more cover there is, the more liquid the business is. It’s a great measure because it takes into account the purpose of liquidity, being the ability to meet cash outflows. A current ratio of less than 1.5 becomes concerning, while a ratio in excess of 2.5 is considered excellent, in general.
The quick ratio is another useful calculation that is a stricter measure of liquidity. It excludes inventory, as it is not necessarily immediately realisable to cash in an emergency. If your business carries inventory that takes longer to sell, then this may be a better measure for you.
Why Carrying Extra Liquidity is a Good Idea
There are many reasons why you might want to be extra conservative as an SME owner or operator. The current environment is highly volatile and unpredictable. Carrying extra cash (or equivalents) is the best way to survive a downturn in business. If your company has to close, suffers from seasonal demand, among many other factors, extra cash allows you to keep paying your bills and even grow your business when others are cutting back.
Late fees cost Australians billions of dollars every year. Just like in our personal lives, businesses are on the hook when they miss a payment. Not only does having sufficient cash on hand mean you’re never stung with a late fee or charge, but you may be entitled to early payment discounts. Some early payment discounts from suppliers run as high as ten or twenty percent – far greater than the return you would likely generate from holding onto the cash or missing the payment altogether.
Another significant advantage of liquidity is the ability to service debt on time. Many businesses rely on debt to fund their working capital. This is excellent when managed appropriately, although it can quickly turn into a disaster if repayments cannot be made on time. Maintaining sufficient liquidity not only reduces costs but has the impact of reducing stress and anxiety for debtholders. If you have money in the bank to cover your repayments, you’re free to focus on other operational areas of the business.
Why Holding Excess Liquidity Might be Bad
On the other hand, focussing too heavily on maintaining excess liquidity may not be the best idea either. There is an opportunity cost associated with holding cash. If you leave cash sitting in the bank doing nothing, it’s not being used for something more productive – such as investing in new products and services or marketing your existing offerings to your customers. This does depend on your industry and competitive environment, however. For example, in the fast-paced tech scene, it would be remiss to not spend capital on research and development while competitors are constantly innovating. There’s no point saving money for a rainy day if you’re really just creating a localised storm!
A potential solution that works well for most businesses is to tie cash flow and liquidity to sales. This means that cash on hand reflects the operational position of the business and lessens the risk that your finances become out of sync with each other. Debtor finance is a great tool that allows your business to access cash sooner from unpaid invoices. Invoice finance providers will pay up to 90% of your verified outstanding invoice value upfront instead of waiting for your customers to pay. It’s a valuable tool to ensure your liquidity is supported throughout the business cycle.
TIM Finance is here to help Australian businesses grow with access to fast and flexible funding. We’re here to help you with your business’s unique financing situation; get in touch today to see what options are available to you.