What ratios measure the ability of an organization to convert assets into the cash it needs to pay off liabilities that come due in the next year?

Table of Contents Show

What Is Liquidity in Accounting?
Key Takeaways
Liquidity Explained
Why Is Liquidity Important?
What Are Assets?
Liquidity of Assets
Most Liquid Assets
Least Liquid Assets
Measuring Financial Liquidity
What Is a Liquidity Ratio?
Using and Interpreting Ratios
Liquidity Examples
Balance Sheet Example
What Is Liquidity Risk?
Liquidity vs. Solvency
How Can Liquidity Be Improved?
10 Ways to Boost Liquidity
How Can Accounting Management Software Help?

Businesses need cash to stay afloat. Even with healthy sales, if your company doesn’t have 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.

Liquidity is a measure companies use to examine their 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.

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. For example, a store that sells collectable stamps might hang onto its inventory to find just the right buyer to get the best price, which means those stamps are not very liquid. But if that same stamp store owns any stocks or bonds, those can be sold quickly, so those investments would be considered liquid.

Companies use assets to run their business, manufacture items or create value in other ways. Assets can include things like equipment or intellectual property. Inventory, or the products a company sells to generate revenue, is usually considered a current asset, because generally 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.

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.

Key Takeaways

Liquidity refers to the company’s ability to pay off its short-term liabilities such as accounts payable that come due in less than a year.
Solvency refers to the organisation’s ability to pay its long-term liabilities.
Banks and investors look at liquidity when deciding whether to loan or invest money in a business.

Liquidity Explained

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 although you may expect to sell your stock, unexpected circumstances might come up and stop that from happening.

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 a 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?

Here are a few of the benefits of taking stock of your liquidity on a regular basis:

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, monitor the financial health of your company and positioning it for strategic growth.
Secure a loan or other funding: Banks and investors look at liquidity ratios when determining a company’s ability to pay off debt.
Benchmark against other companies in your industry: Make and meet goals by tracking what other similar and high performing companies in your industry do.

What Are Assets?

Assets are resources that you use to run your business and generate revenue. They can be tangible items like equipment used to create a product. Or assets can be intangible, like a patent or a financial security. Cash is also an asset. On a balance sheet, cash assets and cash equivalents, such as marketable securities, are listed along with inventory and other physical assets.

Liquidity of Assets

Assets are listed in order of how quickly they can be turned into cash—or how liquid they are. Cash is listed first, followed by accounts receivable and inventory. These are all what is known as current assets. They are expected to be used, collected or sold within the year.

Noncurrent assets follow current assets on the balance sheet. Noncurrent assets include items such as equipment and trademarks. These are assets that can’t be sold for cash quickly.

Most Liquid Assets

Current assets are the most liquid assets because they can be converted quickly into cash. They include cash equivalents, accounts receivable and inventory.

Least Liquid Assets

Noncurrent assets are the least liquid assets because it takes longer to sell them. They include equipment, buildings and trademarks.

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.

What Is a Liquidity Ratio?

Liquidity ratios are a valuable way to see if your company’s assets will be able to cover its liabilities when they come due. There are three common liquidity ratios.

Let’s calculate these ratios with the fictional company Escape Klaws, which sells those delightfully frustrating machines that grab stuffed animals.

Assets

Cash and cash equivalents = $1,000
Accounts receivable = $500
Inventory = $500

Total assets = $1,000 + $500 + $500 = $2,000

Liabilities

Accounts payable = $500
Accrued expenses = $500
Inventory = $500

Total short-term liabilities = $500 + $500 = $1,000

The company also has long-term debt and shareholder equity of $1,000. But those won’t be used in the liquidity ratios because they won’t come due in less than a year.

Current ratio. This indicates the company’s ability to repay business debt with cash and cash-equivalent assets, i.e., inventory, accounts receivable and marketable securities. A higher ratio indicates the business is more capable of paying off its short-term debts. These ratios will differ according to the industry, but in general between 1.5 to 2.5 is acceptable liquidity and good management of working capital. This means that the company has, for instance, $1.50 for every $1 in current liabilities. Lower ratios could indicate liquidity problems, while higher ones could signal there may be too much working capital tied up in inventory.

Current ratio = current assets / current liabilities

Escape Klaw’s current ratio

$2,000/$1,000 = 2

That means the business has $2 for every $1 in liabilities.

Acid test ratio/quick ratio. This ratio is more conservative and eliminates the current asset that is the hardest to turn into cash. In this case, we’ll eliminate the $500 in inventory (one machine). A ratio less than 1 might indicate difficulties in covering short-term debt.

Acid test ratio = current assets – inventory / current liabilities

Escape Klaw’s acid test ratio

$2,000 - $500 / $1,000 = 1.5

Cash ratio. This shows the company’s capacity to pay off short-term debt with cash and cash equivalents, the most liquid assets. A ratio of at least .5 shows healthy cash flow.

Cash ratio = cash and cash equivalents / current liabilities

Escape Klaw’s cash ratio

$1,000 / $1,000 = 1

Using and Interpreting Ratios

Intuitively it makes sense that a company is financially stronger when it’s able make payroll, pay rent and cover expenses for products. But with complex spreadsheets and many moving pieces, it can be difficult to see the financial health of your company at a glance.

Financial ratios are a way to look at your liquidity and measure the strength of your company at a glance using different scenarios, such as covering liabilities with cash and cash equivalents, accounts receivable and even if you had to sell, or liquidate, some of your inventory and equipment. These ratios are also a way to benchmark against other companies in your industry and set goals to maintain or reach financial objectives.

In the example above, Escape Klaws could see quickly that it’s in a good position to pay off its short-term debts. The owner would still want to check in regularly and review the financial ratios to make sure changing market forces don’t disrupt its financial position.

Liquidity Examples

For an asset to be liquid, it must have a market with multiple possible buyers and be able to transfer ownership quickly. Equities are some of the most liquid assets because they usually meet both these qualifications. But not all equities trade at the same rates or attract the same amount of interest from traders. A higher daily volume of trading indicates more buyers and a more liquid stock. Consider a diversity of investments to make capital available when needed.

Balance Sheet Example

A balance sheet is a way to look at how much your company owns and how much it owes at a given point in time. This is where you’ll find the information you need to create your liquidity ratios, which help make this information more digestible, easier to track and easier to benchmark against peer companies.

Using this example, we can calculate the three liquidity ratios to see the financial help of the company.

Current ratio = current assets / current liabilities

$24,000 / $18,000 = 1.33

This means the company has $1.33 for every $1 in liabilities.

Acid test ratio = current assets – inventory / current liabilities

$24,000 – $5,000 / $18,000 = 1.1

A ratio of 1 or more indicates enough cash to cover current liabilities.

Cash ratio = cash and cash equivalents / current liabilities

$16,000 / $18,000 = .89

A ratio above .5 is usually a good indicator of a healthy cash flow.

What Is Liquidity Risk?

CPA Australia defines liquidity risk as the risk that a business will have insufficient funds to meet its current and future financial commitments in a timely manner, without materially affecting its daily operations or overall financial condition. Monitoring these financial ratios allows you to better gauge any liquidity risk, make adjustments or take action.

Liquidity vs. Solvency

Liquidity is a measure of your company’s ability to meet short-term financial obligations that come due in less than a year. Solvency is a measure of its ability to meet long-term obligations, such as bank loans, pensions and credit lines. Liquidity is measured through current, quick and cash ratios. Solvency is examined through other ratios, including:

Debt to assets ratio: How much of your company’s assets were financed through debt?
Interest coverage ratio: Can your company pay the interest expense on its debt?
Debt to equity ratio: How much of your company’s operations is financed with debt?

Short-term liquidity issues can lead to long-term solvency issues down the road. It’s important to keep an eye on both, and financial ratios are a good way to track liquidity and solvency risk.

How Can Liquidity Be Improved?

Finding more and new ways to hold onto and generate cash is a constant search for most businesses. Think about ways to cut costs, such as paying invoices on time to avoid late fees, holding off on making capital expenditures and working with suppliers to find the most cost-efficient payment terms. Try using long-term financing instead of short-term to improve your liquidity ratio and free up cash to invest back in your business or pay off liabilities.

10 Ways to Boost Liquidity

Some of the best ways to boost liquidity include:

Increase sales: It may seem obvious, but more sales will mean more cash flow to your business. Expanding your sales force and new marketing initiatives can help drive sales. Employing different business models can also stoke sales — for example, subscription or recurring revenue models, bundling or unbundling offerings. Examine your profit margins to inform your pricing. But keep in mind, cash may not come in quickly enough to keep up with bills.
Reduce overhead: Overhead costs don’t directly drive revenue to your business. Some examples of overhead expenses are wages, rent, office supplies, insurance, and bank or legal fees. Closely examining your overhead can present surprising cost savings. For example, business situations change, and insurance premiums might decrease as your company matures.
Improve invoice collection: NetSuite Brainyard offers some helpful tips for optimising accounts payable processes to ensure cash flow. These include offering discounts in return for quicker payments, sending reminders on unpaid invoices, look to collect on customers with large payment balances and define weekly cash collection targets. Business accounting software can help you send accurate invoices and track payment. And the accounts receivable turnover ratio can help you track progress.
Pay off debts faster: Liquidity ratios look at assets and debt that will come due in less than a year. Paying down debt will improve your liquidity ratios. Don’t dip too far into cash savings to cover all debts, however. Be sure to anticipate expected and unplanned expenses.
Sell your assets: Are there assets your company has that aren’t helping drive revenue? These are known as unproductive assets and can often be sold to increase cash reserves. Examples include outdated or redundant equipment, unused vehicles or property with no plans for development.
Refinance your debt: Move from short-term to long-term debt where appropriate. This can lower interest rates and have smaller monthly payments giving you more flexibility to meet short-term financial obligations.
Manage accounts payable: Efficient management of accounts payable can also boost your company’s liquidity. When they’re offered, take advantage of discounts for early payment, and negotiate longer payment terms with regular suppliers when they’re not. Don’t pay suppliers early when there’s no financial incentive to do so. And if necessary, prioritise payments to key suppliers to keep your business running.
Watch inventory: Don’t tie up cash in inventory. Closely monitor the inventory to working capital ratio and achieve a balance that is in line with the industry in which the business operates.
Examine and reduce operating costs: When facing a budget shortfall, common areas to cut expenses include business travel, office space, marketing budgets and salaries and bonuses.
Prepare a cash flow projection: NetSuite Brainyard recommends listing all future cash inflows and outflows in cash flow statements by week or month and making sure to calculate ending cash balance at the end of each week or month. This will help the business predict when cash balances may dip below an acceptable level.

How Can Accounting Management Software Help?

Accounting software software helps a company better determine its liquidity position by automating key functionality that helps smooth cash inflow and outflow. NetSuite Financial Management automates more accounting processes and gives you and your finance team easy access to data for analysis — with high impact functions to automate including invoicing, financial report generation, data collection and document storage, and compliance.

The Reserve Bank of Australia's analysis of the financial stability of small businesses demonstrates the importance of facilitating a smooth flow of funds in the economy to support growth. By taking measures into account, such as liquidity, a business can make changes to ensure it’s able to meet its debts, maximise the time it holds onto cash and ensure that if it needs funding from a bank or investor it’s in the best possible position to get that capital.