What is liquidity?
In simple words, liquidity is the ease of converting an asset into cash. Depending on the market and the nature of the asset, we can determine a different level of liquidity for each asset. What do you think is the most liquid asset in the economy? What can be converted to cash at ease? Well, here comes the revelation of the century. The most liquid asset in the word is… cash. Simple right? And next to cash we can convert money in the bank to cash quite easily. However, an asset like a piece of land is comparatively difficult to convert into money right? We would have to advertise, convince buyers and sometimes even hire brokers. An asset like a BB-33 World War 2 Battleship? How hard would it be to sell it and convert to cash? Well, the answer would be pretty hard. Likewise, different assets have varying degrees of liquidity.
Why is liquidity important?
Well, you must always keep in mind that it is vital to maintain sufficient liquidity within your business to handle daily operations and emergencies. Imagine yourself in this situation; You have spent all of your liquid cash and bought machinery for your business. How are you going to handle your daily expenses? Employee wages? Therefore, it is important to maintain a proper liquidity balance in your business.
How to decide on the degree of liquidity?
What can you do with having only liquid cash in your business? Unless you are a “loan shark”, nothing. You need some assets as well! How do we determine the optimum liquidity for a business? Liquidity ratios come handy for this purpose. With the aid of these ratios, you will be able to identify if your business is sustainable in terms of liquidity. These ratios include;
- Current Ratio
- Quick Ratio
- Operating Cash Flow Ratio
The current ratio is the ratio between the current assets of the company in relation to the current liabilities. That is,
Current Ratio = Current Assets / Current Liabilities
This ratio measures if your business is able to pay off all short term liabilities (within a year) using the Current Assets. Investopedia defines current assets as all the assets of a company that are expected to be conveniently sold, consumed, utilized or exhausted through the standard business operations, which can lead to their conversion to a cash value over the next one year period and current liabilities as a company’s short-term financial obligations that are due within one year or within a normal operating cycle. If the ratio is more than 1, it is considered as a good liquidity level. However, we need to compare the current ratio levels of businesses in the industry with ours in order to get a proper understanding.
So the next liquidity ratio is the Quick Ratio. Quick Ratio, also called the Acid Test Ratio, measures the short term liquidity position of an organisation. Quick Ratio measures the ratio between your cash and cash equivalents with current liabilities.
Quick Ratio = Cash and Equivalents + Marketable Securities + Accounts Receivables / Current Liabilities
If you are confused as to what these elements mean, go ahead and give it a simple google search. Here as well, a ratio above 1 is considered an optimum liquidity level.
Now, the last ratio for the day is the Operating Cash Flow Ratio. The name is pretty much self-explanatory. This ratio explains how well the current liabilities of the business can be managed using only the operating cash flows of the business.
Operating Cash Flow Ratio = Operating Cash Flow / Current Liabilities
In this case as well, a ratio above one is considered optimum. Now, when we consider all three of these liquidity measures what we are trying to measure is the efficiency of how we can settle our liabilities using our assets. Hence, maintaining excess liquidity will result in the business profit to decline. As cash in its cash form will not generate any interest or income. Therefore, you always need to invest cash in income-generating activities without letting it lie around for the sake of liquidity. Practice and learn the art of liquidity management. You won’t regret it!