Liquidity
Liquidity definition
Liquidity is a company’s ability to convert assets to cash or acquire cash—through a loan or money in the bank—to pay its short-term obligations or liabilities.
How much cash could your business access if you had to pay off what you owe today —and how fast could you get it?
Liquidity answers that question. According to BDC Advisory Services Senior Client Partner Sean Beniston, it’s a key determinant of your ability to grow.
“Say you go for a loan to buy new equipment or a new building,” says Beniston. “One of the first things your bank is going to look at is your liquidity. If they don’t think you’re liquid enough, your plans could get stalled.”
There’s no magic number or golden ratio when it comes to liquidity. Every business has its own unique needs and considerations. What’s important is to stay aware of your liquidity by measuring the right things over time.
“At the end of the day, it takes money to make money,” says Beniston. “If you can’t access working capital, how do you grow?”
It takes money to make money; if you can’t access working capital, how do you grow?
What is liquidity in business?
Liquidity is an up-to-date measure of a business’s ability to quickly convert assets to cash. Some assets are more liquid than others:
Current assets are the most liquid. They can be used for transactions almost instantly. Of the current assets considered highly liquid, cash ranks at the top of the list. Other kinds of assets, such as marketable securities, accounts receivable, inventory and prepaid expenses, are less liquid because they need to be sold to be converted into cash.
Fixed or long-term assets are considered less liquid because converting them to cash can take months or even years. They also tend to be assets the business needs to function, such as equipment or buildings. These may hold a lot of potential value, but they are not easy to convert into cash.
Liquidity improves when a company generates more in current assets than it does in liabilities.
Businesses in mature industries often have a wealth of very liquid assets because they have a history of bringing in cash. Start-ups are usually less liquid: they don’t have the same access to working capital and loans, and their cash may be tied up in inventory they’re trying to sell.
“You have to work up to liquidity, so younger companies really need to track it closely,” says Beniston. “By measuring liquidity regularly, younger companies can make sure they don’t get caught in a surprise cash pinch.”
You have to work up to liquidity, so younger companies really need to track it closely.
How to measure liquidity
Liquidity is measured using liquidity ratios, which compare assets to liabilities in a business. Common liquidity ratios include:
Acid test ratio (quick ratio): Compares your most liquid assets to your current liabilities.
Current ratio (working capital ratio): Divides your total current assets by total current liabilities. It’s the most common way to benchmark one company against another.
Cash ratio: Divides your total cash by total current liabilities. Considered a “conservative” ratio because it counts only cash as liquid.
How does liquidity affect your ability to grow?
Imagine you’ve just started a field service business—window washing or HVAC repairs, for example. You may want to buy a truck to get around. But if too much of your cash is tied up in that truck, your liquidity could be affected in a negative way that prevents you from getting a loan to hire more people.
“I’ve seen companies with such high demand for their services they can’t keep up without growing, but their working capital position doesn’t allow the liquidity to invest in growth and have to turn business away,” says Beniston.
This is why liquidity needs to be factored into your strategic planning. This way, your growth plans are realistic and based on the working capital you can access.
Double-entry accounting and liquidity
The moment a company incurs debt, two equalizing transactions take place on its balance sheet: the company records a cash balance and a debt. This is called double-entry accounting.
Because of this, using borrowed cash directly affects liquidity. If a company buys inventory, sells it at a profit and generates positive cash flow, its liquidity will go up. If it buys a vehicle or piece of equipment that doesn’t get used or breaks down frequently, the company’s ability to create value with the asset is hampered. Meanwhile, the loan still has to be repaid with cash, which makes liquidity go down.
One nuance here is that if a business buys a fixed or long-term asset with debt, only the current portion of the debt will affect liquidity. After one year, the rest of the loan is recorded as a long-term liability. This means a business can theoretically improve its liquidity by buying long-term assets with debt (though ultimately that affects a different financial measure: long-term leverage).
How to improve liquidity?
Three simple tips can help any business manage liquidity effectively—and factor it into their long-term plans:
1. Measure your liquidity regularly
“If you want to buy assets or grow, you want to measure where you are today and where you need to be,” Beniston says. He recommends setting up dashboards to measure growth and watch for red flags, such as debt or revenue moving in the wrong direction. Tracking liquidity can be done monthly, quarterly or semi-annually.
2. Use liquidity to plan
Measuring liquidity is important on its own, but it is even more powerful when a company sets goals and tracks liquidity measures with a purpose in mind. Once you’ve defined your growth objectives in your strategic plan, you can identify the indicators you need to watch to reach them. Some indicators might be revenue targets or debt elimination goals.
3. Benchmark against your industry
A capital-intensive business like a shipbuilding company will likely have lots of equipment and be paid less frequently than a retailer. It’s natural for the shipbuilder to have less liquidity. That’s why it’s important for companies to benchmark their own liquidity against the average for their specific industry.
Use Statistics Canada benchmarking data to see how you line up. If your current liquidity ratio is 2 (meaning you have twice as many current assets as current liabilities) and your industry average is 1.5, then you apparently have some investable cash. If your industry’s average is 2 and you’re at 1, you’ll want to make changes, as a bank would notice the below-average score.
“We want to see entrepreneurs benchmarking their ratios and setting goals with business objectives in mind. That’s often not done with intention,” says Beniston.
Liquidity is a key planning tool
Measuring your liquidity ratios provides a financial health check of your business and whether you’re making smart decisions that will ensure sustainability. By analyzing your liquidity, you’re essentially asking yourself, “How will my cash flow look in the future?”
If you run a small company, work with an accountant to measure your liquidity and assess whether you’re hitting your targets. Managing your liquidity as you go about the day-to-day challenges of your job can sometimes offset what you want to do in the short term, but it all brings long-term benefits.
Next step
Take the cash flow quiz for entrepreneurs and get tips on better managing your working capital.