“Cash, though, is to a business as oxygen is to an individual; never thought about when it is present. The only thing is the mind when it is absent. When bills come due, only cash is legal tender. Don’t leave home without it”
Businesses need cash to stay afloat. Despite having a healthy sale, if your company doesn’t have the cash to operate, it will struggle to be successful. But looking at your company’s cash position is more complicated than just glancing at your bank account.
“Never take your eyes off the cash flow because it’s the lifeblood of business”
Liquidity is a measure company uses to examine its ability to cover short-term financial obligations. It’s a measure of your business’s ability to convert assets—or anything your company owns with financial value—into cash. Liquid assets can be quickly and easily changed into currency. Healthy liquidity will help your company overcome financial challenges, secure loans, and plan for your financial future.
“No business can succeed to any great degree without being properly organized
What Is Liquidity in Accounting?
Liquidity is a measure of a company’s ability to pay off its short-term liabilities—those that will come due in less than a year. It’s usually shown as a ratio or a percentage of what the company owes against what it owns. These measures can give you a glimpse into the financial health of the business.
For example, you might look at your current and upcoming bills and see that you have enough cash on hand to cover all your expected expenses. Or you might see you need to tap other investments and assets that can be converted to cash. The easier it is to convert the asset to cash, the more liquid the asset is. For example, a store that sells provisions will find it very easy to sell off provisions in an area that is busy. This means the store will have a low-risk level. This means, whenever the store is in debt, it will be easy to sell off inventory to get cash. This shows that the store is a liquid one. However, if the store finds it difficult to sell its inventory for quick cash, the store will be considered illiquid.
Broad Explanation Of Liquidity
Companies use assets to run their business, manufacture items, or create value in other ways. An asset is an item of property owned by a person or company, regarded as having value and available to meet debts, commitments, or legacies. Inventory, or the products a company sells to generate revenue, is usually considered a current asset because it will be sold within a year. For an asset to be considered liquid, it needs to have an established market with multiple interested buyers. Also, the asset must have the ability to transfer ownership easily and quickly. The information you’ll need to examine liquidity is found on your company’s balance sheet. Assets are listed in order of how quickly they can be turned into cash. So, at the top of the balance sheet is cash, the most liquid asset.
Assets And Liability
Also listed on the balance sheet are your liabilities, or what your company owes. Liabilities are listed in order of when they’ll come due. Bills your company will need to pay first are listed at the top. Comparing the short-term obligations with the cash on hand and other liquid assets helps you better understand the financial position of your business and calculate insightful liquidity metrics and ratios.
Assets and investments your company owns have financial value. And liquidity indicates how quickly you can access that money if you need to. Assets range in their liquidity. For example, you may have equity in a building your company owns. But that equity is not very liquid because it would be difficult to convert it to cash to cover an unexpected and urgent expense. On the other hand, inventory that you expect to sell in the near future would be considered a liquid asset. Though it’s still not as liquid as cash because
Measuring liquidity can give you information for how your company is performing financially right now, as well as inform future financial planning. Liquidity planning is coordination of expected bills coming in and invoices you expect to send out through accounts receivable and accounts payable. The focus is finding times when you might fall short on the cash you need to cover expected expenses and identifying ways to address those shortfalls. With liquidity planning, you’ll also look for times when you might expect to have additional cash that could be used for other investments or growth opportunities. To conduct liquidity planning, you’ll perform the same current, quick, and cash ratios we cover later in this article for future scenarios to examine financial health.
Why Is Liquidity Important?
- It Enables You Track The Financial Health Of Your Business You need to have enough cash to meet financial obligations. But holding onto too much cash might leave important investment and growth opportunities on the table. Measuring liquidity helps you find the right balance, monitoring the financial health of your company and positioning it for strategic growth.
- It Encourages Access To Loan And Other Fundings loan or other fundings: Banks and investors look at liquidity ratios in determining the company’s ability to pay off debt.
Assets can be grouped into two; Current assets and Non-current assets. Short-term assets that are used within a year and can easily be converted into cash. Current assets are the most liquid assets.
Noncurrent assets follow current assets on the balance sheet and they include items such as equipment and trademarks. These are assets that can’t be sold for cash quickly. They are less liquid assets
Measuring Financial Liquidity
The concept of liquidity requires a company to compare the current assets of the business to the current liabilities of the business. To evaluate a company’s liquidity position, finance leaders can calculate ratios from information found on the balance sheet.
In conclusion, it is very important to take into consideration how liquid a company can be to avoid bankruptcy.