Understanding and managing cash flow is critical to any business, but it’s not the only measure of financial health that is important to the success of a small business. Liquidity—which is basically the ease with which an asset can be turned into cash—can be just as important for many businesses.
There can be many different reasons why liquidity is important to a particular business, but Paul J. Morrow, Sr., J.D., assistant professor of economics and law at Husson University’s College of Business in Bangor, Maine, says three common ones are:
- To make payments on any borrowings. “Keep in mind that one missed payment is all that a creditor needs to declare default status on a loan,” Morrow warns.
- To meet current cash needs.
Liquidity is the most important indicator of the overall financial health of any small or medium-sized business, says Manny Skevofilax, president of Portal CFO Consulting, Inc., a provider of outsourced financial services based in Baltimore, Maryland. “It’s pretty easy to tell if your business has poor liquidity because you are in a constant scramble to make sure you have enough cash in the bank to meet payroll and pay vendor bills on time,” he says.
The financial metrics most commonly used to measure liquidity are the current ratio (also called the working capital ratio) and the quick ratio. The current ratio (Current Ratio = Current Assets/Current Liabilities) tells you whether you have enough cash on hand to meet all your short-term financial obligations (vendor payments, overhead, payroll) on time. The quick ratio (Quick Ratio = [Current Assets – Inventories]/Current Liabilities) is considered a more conservative measure and is more applicable to businesses involved in retailing, wholesaling, or manufacturing. To determine your quick ratio, subtract inventory from your current assets, and divide the remainder by current liabilities. A quick ratio of 1-to-1 or higher is considered optimal because it means you can meet your current liabilities from assets on hand without having to sell off any inventory.
“Many SMB owners are so busy these days that they don’t have the time or the desire to calculate ratios,” Skevofilax says. “My recommendation to them is that they simply add up the total monthly overhead in their business and make it their prime directive to keep at least two times that number in the bank at all times. Of course, achieving that level of liquidity requires a deep focus on generating profits consistently.”
Is it possible for a business to have too much liquidity? There are varying opinions, but if you find yourself with a quick ratio that is consistently much higher than the optimal 1-to-1, it’s possible you may be missing out on opportunities to apply excess assets in ways that can grow or otherwise improve your business. One danger of too-high liquidity is the temptation to overspend in areas that are not strategically important to your core business mission, warn Doug and Polly White, principals in the business consulting firm of Whitestone Partners, Inc., in Midlothian, Virgnia.
Morrow advises that banks are a great resource for SMBs with liquidity challenges. “They are specialists at computing cash needs,” he says. It’s important to establish a good relationship with a bank, he adds, “because when the business needs quick money, banks have excellent products and expertise in cash management and investment management accounts.”
Disclaimer: Since the details of your situation are unique, you should always seek the services of a qualified CPA, tax advisor, and/or other financial professional.
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