What Is Liquidity?
Liquidity measures how quickly a business or person can convert assets into cash. Some assets convert faster than others.
Current Assets: These are the most liquid and can be quickly used for transactions. Cash is the most liquid, followed by marketable securities and accounts receivable.
Fixed Assets: These take longer to convert into cash, often months or years. They include things like equipment and buildings, which are valuable but not easily sold for cash. A company with more current assets than liabilities is more liquid. Mature businesses usually have better liquidity due to their established cash flow, while startups often have less liquidity because their funds are tied up in inventory or they have less access to loans.
Why Is Liquidity Important In Financial Planning?
Ensuring liquidity is crucial to avoid compromising long-term investment goals for short-term needs.
For Individuals: It’s wise to keep some funds in liquid assets for emergencies. A common recommendation is to save three months’ worth of income.
For Businesses: Businesses need enough liquid assets to cover short-term expenses like bills and payroll. Without this, they risk a liquidity crisis and possible bankruptcy.
How To Measure Liquidity?
Liquidity ratios help assess the financial health of businesses:
Current Ratio: Measures if a company can pay short-term debts with its assets.
Current Ratio = Current Assets / Current Liabilities
Quick Ratio: Similar to the current ratio but excludes inventory.
Quick Ratio = (Cash + Marketable Securities + Accounts Receivable) / Current Liabilities
Cash Ratio: Focuses only on cash and short-term investments to pay off debts.
Cash Ratio = (Cash + Short-Term Investments) / Current Liabilities
Why Is Liquidity Important In Investments?
- Helps Balance Risk & Return: Liquidity helps manage the trade-offs between risk and return in an investment portfolio.
- Facilitates Transactions: Liquid assets, like stocks, can be quickly sold, making transactions faster.
- Simplifies Selling: Liquid assets are easier to sell in emergencies compared to non-liquid ones.
- Protects Investment Plans: Maintaining liquidity prevents the need to dip into long-term investments for unforeseen expenses.
- Maintains Value: Liquid assets generally retain their value when sold, unlike some non-liquid assets.
How to Improve Liquidity?
- Measure Regularly: Track liquidity monthly, quarterly, or semi-annually to monitor growth and identify potential issues.
- Plan Using Liquidity: Set growth goals and identify indicators like debt elimination or revenue targets.
- Benchmark Against Industry: Compare your liquidity ratio to the industry average to determine if you have investable cash.
What Are The Challenges Startups Face In Achieving Liquidity?
- Uncertain Cash Flow: Startups can experience sudden drops in revenue or unexpected expenses.
- Cost Of Maintaining Liquidity: Holding extra cash can reduce ROI, and borrowing increases interest expenses.
- Limited Access To Credit: Startups may struggle to get credit, especially during economic downturns.
