August 2023 |
4 min read time
Lenders and investors often use this factor to assess a company’s financial health. Here’s what owners should know (and do) about it.
Key Takeaways
- Understand the difference between current ratios, quick ratios, and cash ratios.
- In addition to reducing overhead expenses and selling unnecessary assets, digitize processes in your business to free up resources.
- Reevaluate your balance of short-term and long-term debt based on your specific needs.
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A steady stream of cash is key to a successful business, but that’s just one part of your financial picture. It’s also important to maintain a strong liquidity ratio, which indicates the business is able to pay off its existing debts with its existing assets.
The easier an asset is to access quickly, the more liquid it is. Cash is generally the most liquid asset because it’s available at the touch of a few buttons on an ATM pad or a digital app — or sometimes in your wallet. The better a business’s liquidity ratio, the more attractive it will be to lenders and investors, both of which can be extremely important for growth.
While this may sound fairly simple, there are several types of liquidity ratios and ways to calculate them.
Understanding liquidity ratio
One of the most common types of liquidity ratios used to determine a company’s financial health is the current ratio. This compares all of the business’s current assets to all of its current obligations.
Quick ratio and cash ratio are two types of liquidity ratios that lenders and investors sometimes look at. Quick ratio factors in only the business assets that can be accessed relatively quickly, and the cash ratio focuses even more narrowly, comparing obligations to only cash and cash equivalents.
To calculate your business’s liquidity ratio, you simply divide the assets (current, quick, or cash) by business liabilities (debts/obligations).
What the numbers mean
Lenders and investors may use liquidity ratio calculations to determine how healthy your business is. They generally want to know that you have cash flow under control, you spend responsibly, and you pay off your debts. Here’s what counts as healthy, high, or low.
- Healthy current ratio: A business with a healthy current ratio can typically meet its short-term demands and still have enough cash to invest or expand. Generally, a current ratio of 1.0 means that a company’s liabilities do not exceed its liquid assets, though this can vary by industry. Numbers below 1.0 may be acceptable in industries where there’s a quicker turnover in product and/or payment cycles are shorter. In this case, lenders may compare the business’s liquidity score to the industry average to determine its status.
- High current ratio: This refers to a ratio higher than 1.0, and it occurs when a business holds on to too much cash that could be used or invested in other ways.
- Low current ratio: A ratio lower than 1.0 can result in a business having trouble paying short-term obligations. As such, it may make the business look like a bigger risk for lenders and investors.
What business owners can do
Here are five ways to improve your liquidity ratio if it’s on the low side:
- Control overhead expenses. There are many types of overhead that you may be able to reduce — such as rent, utilities, and insurance — by negotiating or shopping around. You can also look at where you expend time and energy. Explore how to identify potential cash shortfalls and tips for more effectively managing your cash flow.
One simple move: If your company has a paper trail, going digital can save you time and money that’s now spent submitting and accepting paper checks. - Sell unnecessary assets. Eliminating items such as surplus business equipment can provide a small sum of capital and reduce the average cost of equipment maintenance. Learn more about selling business-related real estate.
- Change your payment cycle. Talk to your vendors about opportunities for discounts if you pay early, which can save you hundreds to thousands of dollars. On the flip side, you can consider offering your customers discounts for submitting payments ahead of schedule.
- Look into a line of credit. A line of credit could help you cover gaps in cash flow due to payment schedules. Some business lines of credit offer access to up to $100,000 per year, with no annual fee for the first year. If you’re considering this, ask yourself these four key questions — and be sure to compare terms before choosing a lender.
- Revisit your debt obligations. If you have short-term debt, switching to long-term debt can lower monthly payments and give you more time to pay off the sum. On the flip side, switching long-term debt to short-term debt may mean higher monthly payments, but your debt may be paid off more quickly. Also consider options like debt consolidation and loan refinancing, which may help lower monthly payments now, while also saving you money in the long-term.
Contact a Wells Fargo banker to learn how you can start improving your liquidity ratio today.
FAQs
If you discover that your small business has a very low liquidity ratio, particularly below 0.5, it's crucial to take immediate action. Start by cutting unnecessary expenses, accelerate accounts receivable collection, negotiate payment terms with suppliers, and explore short-term financing options if necessary.
What is small business liquidity ratio? ›
It gauges the business' ability to pay back its short-term liabilities with short-term assets. If you have a current ratio of 2:1, you have a financially healthy business.
Why is liquidity important to small businesses? ›
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.
How do I comment on liquidity ratios? ›
A ratio of less than 1 (e.g., 0.75) would imply that a company is not able to satisfy its current liabilities. A ratio greater than 1 (e.g., 2.0) would imply that a company is able to satisfy its current bills. In fact, a ratio of 2.0 means that a company can cover its current liabilities two times over.
What is a good liquidity ratio for a company? ›
A good liquidity ratio is anything greater than 1. It indicates that the company is in good financial health and is less likely to face financial hardships. The higher ratio, the higher is the safety margin that the business possesses to meet its current liabilities.
What is a good current ratio for a small business? ›
Current ratio
It represents how many times bigger your current assets are compared to your current liabilities. This is also called a working capital ratio. A 2 to 1 ratio is healthy for your business. This means you have twice as many assets as liabilities.
What does it mean when a small business owner has low liquidity? ›
It is defined as a business's cash, cash equivalents, and short-term investments divided by its current liabilities. The higher the ratio, the better it is for a company. Conversely, the lower the ratio, the more likely the business will be unable to pay its bills and meet its financial obligations.
What happens if a business has poor liquidity? ›
Poor liquidity, on the other hand, means a business is at higher risk of failing if suddenly faced with unexpected debt, for example, a costly machine repair or a large VAT bill. If the business is unable to convert enough assets to cash quickly to cover the debt it can push it into insolvency.
What are small business liquidity issues? ›
Single Business Liquidity Problem
The root of the problem is usually a mismatch between the maturities of investments the business has made and the liabilities the business has incurred in order to finance its investments.
Why is liquidity ratio important? ›
Liquidity Ratios measure a company's ability to meet its short-term financial obligations. This is important for internal and external stakeholders, as it indicates the company's financial health.
Liquidity refers to the ease with which an asset, or security, can be converted into ready cash without affecting its market price. Cash is the most liquid of assets, while tangible items are less liquid.
How to describe liquidity position? ›
Liquidity is a company's ability to convert assets to cash or acquire cash—through a loan or money in the bank—to pay its short-term obligations or liabilities. How much cash could your business access if you had to pay off what you owe today —and how fast could you get it? Liquidity answers that question.
Why is liquidity and profitability important? ›
Liquidity and profitability are two of your business's most important key performance indicators. In their own way and together, they demonstrate whether your business currently is or can be successful and they indicate your potential for growth and sustainability.
What is a bad liquidity ratio? ›
Low current ratio: A ratio lower than 1.0 can result in a business having trouble paying short-term obligations. As such, it may make the business look like a bigger risk for lenders and investors.
What is the most important liquidity ratio? ›
The most common liquidity ratios are the current ratio and quick ratio. These are very useful ratios for calculating a company's ability to pay short term liabilities.
How do you know if a company has good liquidity? ›
A company must have more total assets than total liabilities to be solvent; a company must have more current assets than current liabilities to be liquid.
What does a liquidity ratio of 2.5 mean? ›
The current ratio for Company ABC is 2.5, which means that it has 2.5 times its liabilities in assets and can currently meet its financial obligations Any current ratio over 2 is considered 'good' by most accounts.
Is 0.8 a good liquidity ratio? ›
Generally, a Quick Ratio of 1.0 or greater is considered adequate to ensure a company's ability to pay its current obligations.
What does a liquidity ratio of 1.5 mean? ›
For instance, a quick ratio of 1.5 indicates that a company has $1.50 of liquid assets available to cover each $1 of its current liabilities. While such numbers-based ratios offer insight into the viability and certain aspects of a business, they may not provide a complete picture of the overall health of the business.
What is a 2.5 liquidity ratio? ›
Interpretation: This company has 2.5 times more in current assets than it has in current liabilities. The premise is that current assets are liquid; that is, they can be converted to cash in a relatively short period of time to cover short-term debt.
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