Liquidity in Small Business: What It Means and Why It Matters
Liquidity is an important concept to understand when managing your company’s finances. It refers to how quickly your company can access cash to cover its short-term obligations such as payroll, bills, and other expenses. A highly liquid company easily turns assets into cash and covers its short-term obligations, while a company with low liquidity may need help to cover its current expenses.
When accountants calculate every ratio of their company’s performance, liquidity is one of the most important metrics. It helps indicate your company’s financial health and provides insight into the short-term sustainability of your business.
What Is Liquidity?
Liquidity is an accounting term that refers to the capacity of a business to generate cash for its short-term obligations. It measures how quickly a company can convert its current assets into cash. More liquid assets (such as cash or marketable securities) can be turned into cash quickly, while less liquid resources (such as real estate or inventory) will take longer to convert into cash.
The current ratio is the most common means of liquidity, calculated by dividing the company’s current assets by its current liabilities. For instance, a current ratio of 1:1 indicates that the company has enough liquid assets to cover its short-term obligations. Meanwhile, a ratio lower than 1:1 indicates a lack of liquidity, while a ratio higher than 1:1 indicates that the company has excess liquidity.
Why Is Liquidity Important?
There are many reasons accountants measure the company’s liquidity, including:
- Providing Insight Into the Company’s Overall Financial Condition. As an entrepreneur, you must know how your business is faring about its ability to pay its short-term obligations. The current ratio is one of the company’s most important financial condition indicators.
- Assessing the Ability to Meet Financial Obligations. The current ratio can evaluate a company’s ability to meet its short-term obligations. A company with a ratio of less than 1:1 may struggle to pay its short-term debts, while a company with a ratio of more than 1:1 may have excess liquidity.
- Ensuring that Funds Are Available for Investing. Sufficient liquidity ensures the company has enough funds to make strategic investments. Without adequate liquidity, the company may not be able to take advantage of profitable opportunities.
- Identifying Potential Financial Problems. Analyzing the current ratio can also help you identify potential financial problems. A low ratio may suggest that the company has problems generating enough cash to cover its short-term obligations. This can be an early warning sign that the company is in financial trouble and needs corrective action.
- Measuring the Company’s Efficiency. You can also use liquidity to measure the efficiency of a company’s operations. For example, if the accountant sees that a company has a low current ratio, it can indicate that it may be wasting or misusing its resources. On the other hand, a company with a high current ratio may be managing its resources efficiently.
Companies should consider their liquidity needs and manage their liquidity accordingly, to ensure that they have enough cash to meet their financial obligations and maintain their financial flexibility. Investors should also recognize liquidity when making investment decisions to ensure that their investments are both profitable and liquid. By understanding liquidity and its importance, investors and companies can make better financial decisions and maintain financial stability.
Ash CPA provides a team of reliable and equipped corporate accountants in MA and the Greater Boston area to help you better manage your financial operations, liquidity, and investments. With our expertise, you can make better-informed decisions and achieve financial success. Book a complimentary consultation with us today!