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What is Liquidity and Learn How to Measure It the Right Way

What is Liquidity and Learn How to Measure It the Right Way

Tuesday May 14, 2019,

13 min Read

A lot of entrepreneurs have trouble understanding the concept of liquidity, as well as why it matters and which assets are actually liquid. Even when they manage to get the grasp of these basic terms, they’re still left to wonder how does one measure liquidity, which factors count, what is liquidity risk and how does one control it. Well, all of these questions are something that needs to be answered, especially if you’re an aspiring entrepreneur on your way towards growing your first enterprise. As the trend of a growing number of startups and small businesses keeps its growth, this becomes more and more of a pressing matter. With that in mind and without further ado, here’s a brief guide on all you need to know when it comes to the issue of liquidity.

What is liquidity?

There are a lot of definitions about what liquidity is but the simplest one would be to say that it’s your ability to convert an asset into cash as quickly as possible (preferably within 90 days). This is why any asset that possesses this ability is also referred to as a liquid asset. Keep in mind, though, that it’s not just your ability to sell, it’s also your ability to sell at favorable terms, which is a simple factor which tends to make things much more complex. Not only is this important for you to understand but it’s also something that can affect the way in which you invest. In other words, it can be a predominant factor for you when you’re coming up with an overall investment strategy.

Why liquidity matters?

Now that we know what liquidity is, it’s crucial that we discuss why is it so important for an aspiring business. As we’ve already mentioned, liquid assets are those that you can access quickly, which means that they’re your first line of defense during any moment of crisis. With the emerging market debt looming above us all, the liquidity may matter more than ever before. This is especially the case when it comes to growing markets and entrepreneurs who have some serious aspirations to transfer their enterprises abroad. The higher your liquidity, the greater adaptability and flexibility you’ll have.

Also, it’s important that one realizes that the market evolves and returns, which is why one’s liquid assets need to change as well. Just because your liquid assets are big enough at the moment, doesn’t mean that they’re bound to stay so in the future. The cost of materials, utilities and workforce could grow, which would mean that you are no longer liquid enough, even though nothing has changed in your organization.

Which assets are liquid?

In the first section, we’ve mentioned that liquid assets are mostly the ones you can access quickly and easily turn them into cash. However, which assets go to this list? In order to start making a differentiation, you need to understand that you need to pick your liquid assets amongst your current assets. Speaking of which, current assets are inventories, prepaid expenses, account receivables, cash in hand, cash at bank, cash equivalents and marketable securities. Out of these seven, the five that are liquid are cash in hand, cash at bank, cash equivalents, marketable securities and account receivables.

Fortunately, even in the most desperate of situations, it’s possible for one to find cash in the most unlikely of places. The first place where one should look is possible tax returns. The reason behind this is the fact that it is cash that you can acquire without any downsides, after all, these are your assets that we’re talking about. You can also look at your insurance plan or go for credit card rewards. From the standpoint of a major enterprise, this may not be nearly enough but for a startup or a small business, this might be just the capital injection one needs.

Diversifying your portfolio

Another thing worth mentioning is the fact that, even though we’ve mentioned the issue of cash, several times over, you don’t actually have to have your liquid assets in cash. Stocks, bonds and commodities can be just as efficient and they’re much more inflation resilient. Also, seeing as how investments and assets of different type don’t respond to the same market rules, this gives one an opportunity to make at least a part of their liquid assets resilient to changes that are about to come. This is what playing it safe looks like and it’s an amazing option to explore when it comes to your liquid assets.

A lot of people decide to keep at least 10 or 20 percent of all their assets in commodities, due to the fact that commodities gain value once institutions, stocks and currencies start losing the trust of investors. Speaking of commodities, the vast majority of people tend to invest in gold or silver, whereas platinum and palladium can be choices that are just as viable. The reason behind this is the fact that these precious metals have wide use in all sorts of manufacturing processes, thus making it less likely that they’ll start losing value anytime soon.

On the other hand, nowadays more and more investors from NSW and Victoria seem to be considering an investment in diamonds as a decent replacement. This makes them turn towards platforms like Australian Diamond Portfolio for information, services and advice. Diamonds, in particular, are a great investment trend, seeing as how they’re easy to transport, have a resilient value and it’s nearly impossible for any agency to make a 100 percent accurate estimate of just how much money you have in these assets.

What are the key liquidity ratios?

There are four major liquidity ratios that you have to keep in mind. First of all, you have the current ratio. This is simple, seeing as how you’re not required to make any advanced calculations but only work with those assets that you already possess. Divide this ratio to total current liabilities and there you have it. There are two things that can be quite problematic that you should understand on this topic. First of all, this ratio sometimes assumes that you can just turn all your assets into cash, which is not always the case in reality, even though it’s correct in theory. Second, even if you do get a value that’s over 100 percent, this is definitely nothing strange.

The next ratio worth mentioning is the so-called quick ratio (also referred to as the acid test). What this does is measure business ability to meet current liabilities from assets that can be sold on short notice. This is actually what most people have in mind when talking about liquidity, mostly due to the fact that it’s the money you can use to make immediate payments.

The third ratio worth considering is also one of the most important notions in the business world, the so-called cash flow. This is concerned with the amount of money that you can use for operational costs. The problem with calculating this lies in the fact that a lot of people put a hard focus on the issue of the net change in work capital that they completely forget about all the other factors that go into it. We’re talking about various non-cash expenses like depreciation expenses, etc.

Lastly, there’s the issue of burn rate, which puts you in a hypothetical situation where you get left stranded without any income and leaves you working only with the cash you’ve got. For how long can you operate only with the amount of money that you currently have available. The reason why this ratio is so popular is due to the fact that it gives you an estimate in days, meaning that it’s a metric that’s incredibly easy to follow. Some other metrics deal in absolutes (yes or no) or even in percentages, which can be incredibly hard to pinpoint. With burn rate, you’ll get a metric that’s a lot more tangible.

Ratio interpretation

The next thing you need to understand is the fact that it’s not just the rations that you have to worry about but the ratio interpretations, as well. Their interpretation is important so that you can see whether or not your company is moving in the right direction, as well as to unveil the true resilience of your company (liquidity vouches for resilience). One more reason why ratio interpretation is so important is due to the fact that it allows you to compare yourself and your success to others within your industry. For instance, if a company belongs to the same industry as you and is of the relatively same size, comparing your liquidity to theirs would give you a chance to see exactly where you’re standing.

It’s also important that you understand that the context matters quite a bit, which is why it may impact your interpretation. For instance, we’ve already mentioned that all the assets that you can sell for cash within 90 days are supposed to be liquid assets, yet, there are some scenarios in which you won’t have that much time. The worst-case scenario estimate differs from your standard evaluation by quite a bit, which is something that you should always bear in mind.

Relevant factors for making the calculation

Previously, we went to lengths to discuss various ratios, yet, these ratios can’t be calculated without the aid of various factors. For instance, the first thing that a person in charge of determining the liquidity of a company would have to do is take a look into the amount of money they have in their bank accounts. Cash in banks can be quickly withdrawn, which makes it into an epitome of liquid asset.

Other than this, you also need to consider account receivables, due to the fact that its money that you’ve already earned and are now just collecting. Keep in mind that account receivables can be sold to a factoring company, thus quickly being converted to cash. Another asset that behaves similarly to the above-discussed two are the contents of your inventory. This is due to the fact that it can be sold fairly quickly, even though you would, most likely, do this at a certain loss.

There are also some factors that represent your financial obligations, which you also have to keep in mind when it comes to the issue of liquidity. We’re talking about trade payables, current maturities of long-term debts, accrued expenses, short-term notes payables and several other factors that we won’t focus on, at the moment. Overall, only when you have all of this, will you have all that you need in order to measure your liquidity.

Net working capital

Previously, we’ve mentioned the importance of having a metric that you can really understand, like when your liquidity is presented in days. Well, net working capital is a similar metric, seeing as how it doesn’t deal with rates, ratios or percentages but gives you a simple estimate of how much money you’re working with (minus liabilities). For practical reasons, this is one of the most important metrics that you’ll encounter when it comes to your liquidity, which is why it’s essential that you approach this issue with a lot of attention and focus.

What is liquidity risk?

Once you know all of this, it’s time that you get familiar with the term liquidity risk. These are the situations in which your business ends up with a negative working capital due to your inability to meet all your financial responsibilities. During a recession, this becomes a phenomenon of epic proportions, yet, it’s something that can happen even when the market is in a perfect balance. Naturally, there are a couple of factors that you need to know on this topic.

First of all, there are several things that can increase the liquidity risk in even some of the most responsible and diligent businesses, most notably, the inability to meet short-term debt due to losses that were bigger than predicted. It gets even worse, seeing as how your inability to pay isn’t all there is to your liquidity problems. Failure to pay in time is just as better. Remember that a lot of startups and small businesses depend on these payments, which is why a failure to meet a single payment can end up being catastrophic. Lastly, there’s the issue to an unforeseen rise in materials, which would make you operate at a loss even if your profit did manage to meet your intended goals.

The way in which you calculate the liquidity risk is an incredibly important thing. The concept of the equation is fairly simple, seeing as how you get to calculate the ratio of your current (short-term) liabilities as per current liabilities. Needless to say, it would be best if the ratio is above 1. This would mean that your current income is sufficient to cover your current expenses.

How to control liquidity risk?

By far the most important thing on this subject is knowing how to control the liquidity risk in question and there are several methods that you can always turn towards. First of all, if you believe that this is a one-time problem or an anomaly, it can all be sorted out with a simple short-term loan or even a bank overdraft. Keep in mind, however, that paying back this loan also adds to your list of financial responsibility, thus increasing your liquidity risk. This is why you need to consider your (realistic) future earnings and see if this is a sustainable system.

In some scenarios, the increase in liquidity risk would be caused by the client who has canceled the order after the manufacturing process has already started (or even finished). In that particular case, all you would be able to do is find a new buyer for the products or invest heavily in your marketing efforts, so that you can sell these products to other buyers. While this is an unnecessary expense (the cost of acquiring a new client), the truth is that the alternative is far worse and, therefore, not even an option worth considering.

In some scenarios, the costs of running a business can rise too high due to political or economic reasons that you can’t affect. We’re talking about global trends and policies, as well as political matters. In this particular scenario, the cost of labor, the cost of supplies such as raw materials and similar factors would skyrocket in value. In that particular scenario, a lot of entrepreneurs would consider relocating their business (to another country or even a continent). Still, due to the fact that this is a bit of an extreme scenario, it’s something that should only be considered in the most extreme of situations.

In conclusion

The very last thing you need to understand is the fact that while liquidity matters, it’s definitely not all that matters. However, everyone knows that even the best idea can’t do much unless there are finances to support it. So, even it may not be the only thing that matters, the issue of liquidity gets pretty high on your priority list. Different experts and companies may have different approaches to this issue and knowing which approach to take may significantly turn the tide in your favor.