Understanding and managing cash flow is critical to any business, but it's not the only measure of financial health that's important to your business’ success. Liquidity — which is basically the ease with which an asset can be turned into cash — can be just as important.
The 3 most common reasons why liquidity is important to your business are:
- To make payments on any loans your business has taken out (keep in mind that one missed payment is all a creditor needs to declare default status on a loan)
- To meet current cash needs
- To avoid unpleasant surprises
The financial metrics most commonly used to measure liquidity are the current ratio (also called the working capital ratio) and the quick ratio.
The current ratio tells you whether you have enough cash on hand to meet all your short-term financial obligations (like vendor payments, overhead and payroll) on time. To calculate your current ratio, divide your current assets by your current liabilities.
The quick ratio is considered a more conservative measure of liquidity and is more applicable to businesses involved in retailing, wholesaling or manufacturing. To determine your quick ratio, subtract inventory from your current assets, then divide the result by your current liabilities. A quick ratio of 1 or higher is considered optimal because it means you can meet your current liabilities from assets on hand without having to sell off any inventory.
Is it possible for a business to have too much liquidity? There are varying opinions on this issue, but if you find yourself with a quick ratio that is consistently much higher than the optimal 1, it's possible you may be missing out on opportunities to apply excess assets to grow or improve your business. One potential danger of too much liquidity is the temptation to overspend in areas that aren’t strategically important to your business’ core mission.
Banks are a great resource for small businesses with liquidity challenges because they're specialists at computing cash needs. It's important to establish a good relationship with your bank because when your business needs quick money, banks have excellent products and are experts in cash management and investment management.