The importance of liquidity in the life of a business
Liquidity is solvency and the ability to be monetised. (Not to be confused with liquidation 🙂)
Naturally, you direct your money to where you expect the most from it, and that’s why liquidity planning isn’t always taken for granted.
Getting the most out of your money typically means returning to your own business for a business. In the event of a crisis, dust can easily get into the machinery, which can also send your company to the floor. That’s why it is useful to see a few things more clearly about this.
Even without a crisis, inadequate liquidity management have been pushed to the brink of bankruptcy many companies, so it is always timely and necessary to deal with this.
What does liquidity mean in the life of a company?
Liquidity means how well you are able to meet your payment obligations on time. This, of course, requires liquid assets.
What are liquid assets?
The liquidity of an asset is shown by how easily and quickly it can be converted into money. That doesn’t mean it retains its value, it’s just that it’s easy to find a “buyer” for it.
The most liquid asset is cash. Can be used anytime, accepted everywhere. Of course, this does not mean that banknotes should always be stored in bags at home.
Equities and other money market investments fall into the liquid category in terms of liquidity. This does not mean that they will keep the value you gave them when you bought them.
After all, you invested them to make a profit on them. But if their value can go up, it can also go down, so selling out of coercion can even be a loss to you. They are considered liquid assets because when you decide to sell, you know exactly how much cash and in how many days you will receive for them, regardless of their current value.
At the other end of the scale are the least liquid assets, such as
- the property
- works of art
What are the benefits of maintaining liquidity?
For a business, the amount of cash available does not necessarily determine whether or not to take on a particular order.
Take an example of a construction business getting an assignment to build a larger property. Naturally, they do not have the cash to complete the entire project. That wouldn’t even be realistic.
A business needs to know to make a decision how big it is their
- liquid reserve: from this they can start working immediately, this usually means cash.
- short-term liabilities: this is expected to flow in within a year, so they can continue working from this
- the stock of assets that a bank can lend to: it is able to make higher capital-intensive investments until the customer pays.
If you know these three, you will be able to tell exactly if you can pay the costs during construction on time. If it is going to work foreseeably, you will obviously accept the assignment.
And with that, we came to the second advantage.
When a business turns to a bank to take out a loan, the bank looks very closely at the chances of a possible loan default. (After all, the bank would then be jeopardizing its own liquidity and, at the same time, its customers.)
In this case, one of the areas of emphasis is the liquidity management practice so far. Naturally, the bank is reluctant to risk customers’ money in a direction where there have already been payment difficulties. However, they prefer to give money to a place where had been treated with due care so far.
Sure, on a secure basis, the bank also tends to ask for real estate collateral, and they going to look into that as well. Because what if dust gets into that machine? In the case of investment loan (It is for one of a greater value investment), it is advisable to offer real estate as collateral. This makes the loan cheaper for the business.
Where there has been no difficulty in paying for years, this custom is likely to continue. Thus, on the one hand, the repayment of the loan will not cause such a burden, and you will also be able to buy real estate from the profits already made, so the collateral of the loan is also adequate.
This brings us to the third area.
For a company, it is extremely important to put proper emphasis on liquidity management, otherwise risks bankruptcy.
It also happens to a stable, well-functioning business that may have payment problems. However, this occurs regularly in a company where there is no such focus.
A company that runs after the market may start loosing control after the first problematic month.
However, where emphasis is placed on liquidity and, through it, stability, they are able not only to survive a period of crisis, but also to retain the professional team they have already built up.
What can cause stability to lose?
Of course, it is not just a crisis or quarantine that can cause liquidity problems. It is enough to add a change in the law, the appearance of a new competitor, or just a change in customer taste. You have to adapt to this as an entrepreneur, and since it doesn’t go overnight, you need to have some reserve.
To determine, plan, and maintain your liquidity, it is essential that you know your own financial background, have proper discipline in the records, and maintain a close relationship with your accountant / financier. Without knowing the numbers, you can’t determine or plan your company’s liquidity.
Calculation of liquidity
There are several methods available to determine a company’s liquidity. Let’s take a look at the most commonly used methods, you can read more about liquidity ratios in this post.
Liquidity ratio = Current assets / Current liabilities
You can read both your current assets and your current liabilities from your balance sheet, and your accountant can give you effective help.
The liquidity ratio shows the coverage of short-term liabilities in the broadest sense. It shows how many times the value of a current asset considered as a liquid asset is the liability due within a year. The higher the value, the more stable the operation of the company.
The composition of current assets is key to liquidity. Thus, this category is also used to narrowed. By omitting stocks from the above formula, we obtain the Liquidity Rate. The simple reason for leaving stocks is that it is absolutely necessary for the continued operation of the business. Although it can be sold if you really have to, but with that we would undermine later revenues.
Liquidity rate = (Current assets – Inventories) / Current liabilities
The value between 2-4 can already be considered particularly good, because then the company can be said to be very stable. The low value, on the other hand, indicates payment difficulties. The higher the value of the indicator, the more stable the company can be said.
If necessary, it may be justified to further narrow this, in which case we will obtain the liquidity of the funds. This is practically nothing more than a company reserve.
In case of healthy operation, a reserve is required,
Normally, it is usually recommended that the emergency reserve cover the subsistence of 3-6 months for an individual, and for businesses this should be closer to the 1-year reserve. Thus, it is not a problem if someone does not pay on time (in the event of a crisis, almost no one pays on time).
How much this is for you is based on the coverage point in calculating it. (In a nutshell: you need to pay the fixed costs, you have to do this even if the sales stopped or, at your own discretion, in addition to the fixed costs, it is worth paying the variable costs to restart later production.)
Cash liquidity = cash / current liabilities
However, a high value for this indicator can be misleading.
Although it is important in the life of a company to have a reserve to cover a minimum of 6 months’ subsistence, the above parts may already show that the company is not producing with this money.
High value usually occurs when
- suddenly came more revenue do not want to waste the company,
- or just making some major investment and not wanting to maintain too large loan portfolio.
- For how many months do you have sufficient reserves to maintain liquidity?
- How often do you review this category?
- How do you allocate the cash in excess of the 3-6 month reserve to the equity of a subsequent investment?
Whether you have a question about how you can build up the capital needed for a later project, or your cash holdings in your bank account are temporarily too high, contact us. You know, there should be two unnecessary questions sooner than a necessary one in retrospect.