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 the benefits of a strong liquidity position for your business.
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:
- Current ratio: the simplest way to measure liquidity. It divides your current assets by your current liabilities.
- Quick ratio / acid test ratio: a stricter form of the current ratio.
- Cash ratio: the strictest liquidity measurement – only counts cash and cash equivalents as liquid assets.
For a detailed explanation on how to calculate your liquidity using each ratio, read our article on liquidity ratios.
Why is Liquidity Important for a Small Business?
Here are the main reasons why liquidity – and tracking your liquidity position – is important for your business:
- Indicator of financial health. Your liquidity position is a good indicator of the financial health of your business.
- Pay bills and operating expenses. To pay your bills and operating expenses, you need liquidity. At the very least, make sure your cash position covers your short term obligations.
- Avoid going into debt. If you have a strong liquidity position, you can handle unexpected expenses – and avoid having to take out a loan or business financing to cover those expenses.
- Continue operating during economic downturns and slow times. Maintaining a liquid financial cushion of at least 3-6 months gives you some breathing room if your business slows down or you face unexpected economic hard times – such as the COVID-19 pandemic.
- Enables business growth. With strong liquidity, you put yourself in a position to act when a growth opportunity arises – you’ll have funds available to deploy when it makes sense.
Consider this example: a local jewelry 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 jewelry 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.