Liquidity is the ability your business has to pay bills from suppliers and cover fixed costs, as well as unforeseen expenses.
Having enough liquid assets—such as cash and bank deposits—is called having good liquidity. This is extremely important for your business.
If you have good liquidity you can smoothly handle day-to-day-operations, cover unforeseen expenses and take advantage of strategic opportunities to expand, invest, and take on new projects.
Calculate the liquidity ratio of your company
If you want to know if your company has good or bad liquidity, you need to calculate the liquidity ratio. The ratio shows how well you’re able to pay what you owe, also called liabilities.
There are four types of liquidity ratios you can calculate, but the most common ones are liquidity ratio 1 and 2. The current ratio includes all current assets, while the quick ratio only includes liquid assets and excludes inventory. This makes the quick ratio a more conservative assessment.
Liquidity ratio 1: Current ratio
Formula: Current assets divided by current liabilities
If your current assets are $100 000 and current liabilities are $80 000 the calculation is:
$100,000 / $80,000 = 1.25 or 125%
A current ratio above 100% indicates that you have more current assets than you need in order to cover your expenses.
However, since it’s not 100 percent guaranteed that you’ll receive payment from all the customers you’ve invoiced, aiming for a ratio of 2 (200%) or higher is good to ensure a robust liquidity.
Liquidity ratio 2: Quick ratio
Formula: Current assets minus inventory divided by current liabilities
If your current assets are $100 000—but $40 000 of that is your inventory—and current liabilities are $80 000 the calculation is:
Calculation: ($100,000 – $40,000) / $80,000 = 0.75 or 75%
The quick ratio, excluding assets that aren’t as liquid, should ideally be above 100% to ensure good liquidity.
Set up a cash flow budget
All companies should have a cash flow budget. It makes it much easier to ensure good liquidity. It doesn’t have to be a complicated budget, but it can make a big difference in how you run your company.
In a cash flow budget, you’ll estimate how much cash flows into and out of your business for the upcoming period. This difference is often called the budgeted cash flow result and shows how much money you will have left over after the period. The money you have left can be used to make investments, buy raw material, hire employees, or just to have on hand in case of unforeseen expenses.
The cash flow budget might, for example, show you that your income varies a lot from month to month, and so you can see that you need to set aside a little extra for the months where you might go below your budget.