No matter your industry, you need cash to stay in business, especially during periods of economic instability or inflation. Liquidity is a way that companies measure their ability to gain access to cash to cover short-term obligations.
Here’s a deep dive into the importance of liquidity in accounting and why it matters for modern businesses.
What Is Liquidity?
Liquidity refers to how easy it is to convert an asset into cash. A “liquid” asset is one that can be easily converted into cash without affecting its market value. This is important because companies typically possess a wide range of assets in addition to actual cash.
Cash is the most liquid asset of all since it can be universally spent, but companies also possess assets like:
- Property and equipment
- Accounts receivables
- Intellectual property
- Marketable securities
- Product designs
Unlike cash, these other assets can’t always be readily converted into working capital. As a general rule, tangible assets are less liquid than cash or even some stocks since you’ll need to have a buyer lined up to convert things like property, inventory, or equipment into cash.
How Is Liquidity Measured?
You can measure liquidity using three different methods. While all these methods can be useful, each comes with certain assumptions and limitations that may make it more appropriate for certain situations.
The current ratio simply measures current assets against your current liabilities. You can calculate your current ratio using the following formula:
Current ratio = current assets / current liabilities
The advantage of this method is that it’s the quickest and most direct, though it assumes that all of your assets have the same degree of liquidity, which isn’t necessarily the case.
Quick Ratio (The Acid-Test Ratio)
The quick ratio, or “acid-test” ratio, focuses exclusively on liquid assets such as cash and its equivalents and excludes illiquid assets such as inventory or equipment. You can calculate the quick ratio using the following formula:
Quick ratio = (cash and cash equivalents + short-term investments + accounts receivables) / current liabilities
A simplers version allows you to subtract your inventory from your total assets:
Quick ratio (varied method) = (current assets – inventories – prepaid costs) / current liabilities
This method is quicker, though it also requires a clear understanding of the value of your current assets.
The cash ratio defines liquid assets as exclusively cash or cash equivalents and excludes all other business assets. You can calculate the cash ratio using the following formula:
Cash ratio = cash and cash equivalents / current liabilities
This is perhaps the most reliable approach in the event of an actual emergency, as it shows you how readily you can gain access to working capital without having to sell your tangible property.
Why Is Liquidity Important for a Business?
If you work in finance, you’ll need a firm understanding of your organization’s current finances and your liquid assets. Here’s why liquidity in accounting matters for modern businesses.
Gauging Your Emergency Preparedness
One of the most important reasons liquidity matters is that businesses need to understand how readily they can respond to emergencies. Liquidity helps company leaders understand cash flow and determine how to cover their bills if they end up facing unexpected costs.
Inflation, for example, represents a season when businesses will struggle to meet their overhead expenses. Liquidity can help companies learn more about their financial health and provide a plan if they need to tap into cash quickly to stay afloat.
Taking on New Projects
Liquidity can also tell you how easily you can tap into cash for a new business project.
A high level of liquidity can indicate that you’re able to cover the cost of new business ventures, expansion projects, and more. Conversely, having low liquidity may mean that a new project is too great a risk for the time being and needs to wait until another season.
Business owners often rely on external financing to meet new financial needs or undertake expansion projects. Banks and business lenders will expect to see your liquidity ratios before approving any sort of loan. Having this information prepared can increase your ability to secure the financing you need.
Comparing to Other Companies in Your Industry
Liquidity ratios can be compared to other companies in your industry or even your geographic area. This data can help you track how well your company is performing compared to similar-sized companies and set goals accordingly.
Understanding Liquidity in Accounting
Understanding liquidity in accounting is crucial to understanding your organization’s financial health, particularly during periods of economic volatility. Having a higher degree of liquidity can ensure that your organization can weather the financial storm.
This has been part one of a two-part series on liquidity. To learn more, make sure you read part two and find out how to increase your company’s liquidity.