Understanding short-term liquidity and its working

Suppose you apply for a loan to buy a building. However, the loan gets rejected as you don’t have enough “short-term liquidity”. 

Let’s understand this in detail.

Liquidity is your ability to convert assets to cash. The easier it is to convert your asset into cash, the more liquid it is. Coming back to the scenario where you applied for a loan, the bank will judge your liquidity depending on how much cash your business has access to, if you had to pay off the amount you own today and how fast you can do it.

If you are a fairly new company like a startup, then you must track your liquidity regularly so that you have access to emergency cash.

Different types of assets

Some assets can be more easily converted into cash than others:

  • Fixed or long-term assets

Owning a fixed asset can be tricky when applying for a loan. This is because they are considered less liquid, as it might take months or years to convert them to cash.

For instance, if you want to convert a residential property to cash, it may take approximately a couple of weeks, or 2 months and sometimes even a year to complete the sale and receive the funds in exchange.

Fixed assets also include assets your business needs to function, like a building or equipment.

  • Current Assets

They can be easily converted into cash and are considered the most liquid. Current assets like cash can be instantly used for transactions which can have probability of margin liquidation. Other current assets are accounts receivable, inventory, and prepaid expenses which are less liquid as you can quickly convert them to cash. The liquidity of your business improves when you have more current assets than liabilities. 

Let us dive deeper to understand short-term liquidity better.

Short-term liquidity 

Short-term liquidity is the ability of a business to fulfill short-term financial commitments. Many assets, like current assets, can be easily converted into cash or cash equivalent within a short period. These assets usually rank high on the liquidity spectrum.

Significance of short-term liquidity

  • Regular expenses

Your business requires a certain amount of funds to keep up with the regular expenses. So if you have low liquidity, you will have trouble keeping up with expenses. Well, you may think of taking a short-term loan if you have a financial crunch. But wait, that is a bad idea, as a short-term emergency loan will greatly impact your credit score and increase your business’s risk.

Short-term liquidity makes it easier for you to run your business.

  • Emergency funds

Suppose your factory catches fire or the main manufacturing equipment is not functioning at all. This will have a huge impact on sales. However, if you have current assets, it acts as a safety net to keep up with your expenses, and you have enough time to fix the issue.

  • Track financial health

Looking at the amount of liquidity helps you understand how much financial barrier you have. It also helps you keep tabs on the financial health of your business.

  • Loans are easily approved.

If you own more current assets, then the short-term liquidity of your business is higher. This greatly impacts your ability to get financing from investors or banks. Moreover, you will get better interest rates, and there will be lesser restrictions.

  • Improves Decision-Making

You can use the liquidity level of your business to make financial decisions. Let’s say that your liquidity is on a higher scale. In that case, you can look to invest in improving your infrastructure, such as updating your equipment or expanding your market region, or you can even shift to a larger space.

Simply put, you can refer to the liquidity level before making a big business decision.

How can you measure the liquidity of your business?

Liquidity is usually measured by investors using liquidity ratios, where your assets are compared to liabilities. Some of the common liquidity ratios are:

1. Current ratio/working capital ratio

It is calculated by dividing the total current assets you own by your current liabilities.

2. Acid test ratio / quick ratio

It is a ratio of your most liquid assets to your current liabilities.

3. Cash ratio

It is calculated by dividing the total cash you have by the total current liabilities.

How does liquidity affect your growth?

Suppose you have started a cleaning company and require a big vehicle or a truck to move around. However, if you have invested too much in the truck, the business’s liquidity can be negatively affected, so you might not get a loan from a bank to hire more employees.

This is why you must consider liquidity in strategic planning before investing in a big asset. In this way, all your plans will be realistic, and your ability to grow is not affected.

Conclusion

Short-term liquidity is important because businesses constantly need money to meet their short-term obligations. Without cash, you won’t be able to buy raw materials or pay wages to your employees.

FAQ

1. What happens if you are liquidated on margin?

If there is a probability of margin liquidation, then you may be forced to sell your assets to the financial institution unless the value of the margin has been satisfied.

2. How to improve liquidity?

You can improve your liquidity in the following ways:

  • Benchmark your liquidity against the average in the market
  • Keep track of your liquidity
  • Always keep liquidity in the equation during strategic planning

3. What are the three types of liquidation?

Three types of liquidity are:

  • Creditors voluntary liquidation
  • Forced or compulsory liquidation
  • Members voluntary liquidation

4. What is a good liquidity ratio?

Anything above 1 is considered a good liquidity ratio, proving that a company has enough current assets and is worth the investment.

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