According to a study by JP Morgan & Chase, the median U.S. small business holds an average cash balance of $12,100 (with significant variation across industries).
That works out to only 27 cash buffer days; which are the number of days a business can afford to pay its cash outflows without further cash inflows. So, the average small business has less than one month’s worth of cash saved for a rainy day; though the recommended rule of thumb is to keep at least 3-6 months of cash reserves ready for use at a moment’s notice.
Sadly, many small businesses learned this lesson the hard way, as COVID-19 lockdowns and capacity restrictions crippled their operating cash flow while they continued paying expenses just to keep the lights on.
That’s why it’s critical for you to understand your liquidity position and proactively prepare for the worst case scenario. Doing so will help your business meet operating and financial obligations, regardless of external circumstances.
In this article, we’ll explain what liquidity is, how to calculate it, and share our top tips to improve your business’s liquidity and financial position.
What is Liquidity?
Liquidity is a measure of how easily a business can convert its assets into cash at their fair market value.
In other words, liquidity is the “closeness” of an asset to cash – the more easily an asset can be turned into cash, the more liquid it is, and vice versa.
By definition, cash is the most liquid of all assets, as it can be used to pay business expenses and meet financial obligations without additional conversion.
Other assets, like accounts receivable, inventory, and property, must be liquidated first (either collected as cash or sold for cash) before they can be used to fund expenses or repay creditors.
A few examples of liquid assets are cash equivalents like guaranteed investment certificates (GICs), marketable securities like stocks or bonds, and accounts receivables.
These types of assets can be sold quickly on a public market, as in the case of stocks and bonds, or collected as cash in a reasonable amount of time, as in the case of accounts receivables from customers.
This makes liquid assets valuable in the event of a cash crunch, as your business can quite easily turn them into cash to meet unexpected expenses.
Illiquid assets, however, are those that require both time and resources to convert into cash.
Raw materials, vehicles, and property, plant, and equipment (PPE) are some common examples of illiquid assets.
Illiquid assets are difficult to sell quickly for their fair market value. As a result, a business may need to take a loss in order to liquidate these assets in a timely manner.
Consider this example: a local landscaping company needs to raise cash to make an upcoming loan repayment and decides to sell one of its extra trucks to meet the obligation, due to a lack of liquid assets.
However, the company is forced to sell the truck for far below market value to get a deal done in time. If the landscaping company had more liquid assets, it could have used them to make the loan repayment and waited for the right deal on the truck.
How to Calculate Liquidity?
So far, we’ve defined what liquidity is but haven’t explained how to calculate it. That’s because liquidity is a rather vague term that doesn’t have a one-size-fits-all formula.
However, there are a few popular liquidity ratios that can provide insights into the financial health of your business. We explain each one and how to use them below.
The current ratio is the simplest way to measure liquidity and is calculated as follows:
Current Ratio = Current Assets / Current Liabilities
- Current assets are assets that can reasonably be converted into cash within one year – examples include cash and cash equivalents, marketable securities, accounts receivable, and inventory.
- Current liabilities are liabilities that need to be repaid within one year – examples include accounts payable, current portion of deferred revenue, dividends payable, and income taxes due in a year or less.
By dividing the two, the current ratio measures how easily current liabilities can be met using only current assets.
A current ratio of 1 or greater means there’s sufficient current assets to pay all current liabilities, while a ratio below 1 means there’s a gap.
However, not every business needs or should strive for a current ratio above 1 as it would be inefficient to hold more current assets than you need to run your business. It’s better to compare your business’s current ratio against benchmarks in your particular industry or against close competitors.
While the current ratio is a good start to understanding your business’s liquidity, it’s not as strict as some of the other ratios that we’ll discuss next.
Quick Ratio / Acid Test Ratio
The quick ratio or acid test ratio is a stricter form of the current ratio that only includes highly liquid current assets.
The quick ratio is calculated as follows:
Quick Ratio = (Cash + Cash Equivalents + Marketable Securities + Accounts Receivable) / Current Liabilities
Under the quick ratio, only current assets that can be liquidated in 90 days or less are included, such as cash and cash equivalents, marketable securities, and accounts receivable.
Most notably, the quick ratio excludes inventories, as they are often difficult to liquidate in a short period of time. However, in actuality, this depends on the nature of the inventory – a gas station with gasoline and diesel as its primary inventory can easily liquidate them in a few days, while a car repair shop with used car parts as inventory may need weeks or months to find a suitable buyer.
In addition, you may wish to exclude accounts receivable (revenue owed by customers for products or services that have been performed, but not yet received) from the quick ratio as well, depending on your industry.
In some industries like construction, customer accounts regularly take more than 90 days to collect, making accounts receivables unsuitable for the quick ratio.
Overall, think of the quick ratio as a “stress test” of your business’s liquidity during a short-term emergency. A quick ratio above 1 indicates a highly resilient business that can meet all its current liabilities in under 90 days.
Again, it’s best to compare your business’s quick ratio against industry benchmarks and close competitors to draw more accurate conclusions.
Finally, the cash ratio is the strictest liquidity measure as it only counts cash and cash equivalents.
The cash ratio formula is as follows:
Cash Ratio = (Cash + Cash Equivalents) / Current Liabilities
In short, the cash ratio simulates a worst case scenario, such as a financial crisis, when even highly liquid assets like marketable securities and accounts receivable cannot readily be converted into cash.
If your business has a cash ratio of 1 or greater, that means you can withstand even the most difficult financial situation by meeting all your current liabilities using only cash and cash equivalents.
Why is Liquidity Important for a Small Business?
Having a strong liquidity position allows your business to operate with minimal interruption when there’s an industry slowdown or economic downturn, without being forced to sell assets at a discount or lay off employees.
Consider this example: a local jewellery store was burglarized and lost a lot of valuable inventory. While the owner had insurance on the stolen items, she had to wait several months for the claim to be processed.
Until then, the jewellery store still needed cash to pay rent, staff, and other expenses. Due to years of meticulous planning, however, the store owner had set aside enough cash reserves, along with access to multiple lines of credit, to fund the business for at least six months. This allowed the store to continue operations while waiting for the insurance proceeds.
Improve Your Liquidity Position with Gravity Capital
At Gravity Payments, we understand that it’s difficult for small business owners to always have enough liquidity, since operating and growing a business requires a lot of cash.
That’s why we launched Gravity Capital; it helps your business raise cash when it’s needed with quick, easy, and flexible funding solutions.
Apply today to see how much your business qualifies for and learn more about our adjustable repayment timelines that scale with your business.