How to Measure Liquidity in Your Business
Liquidity is a valuable tool for all business owners. A liquid asset or security is one that can be converted into cash quickly and without affecting the market price of that asset. The easier it is for an asset to be converted into cash, the more liquid it is. Accounting liquidity is a measurement of how easy it is for a company to meet its financial obligations with the liquid assets it has, such as to pay off its debt.
Understanding this concept is important to businesses as it provides insight into the financial health of a company, among other things. It may impact whether potential investors and creditors wish to work with the company. It also sheds light on the company’s perceived stability.
There are a few ways to measure liquidity in your business.
Cash Conversion Cycle
The cash conversion cycle (CCC) is our #1 ratio and leading indicator we look to when reviewing our client’s financial performance. The CCC shows how many days it would take a company to convert its investments into cash flow from sales, and is an indicator of how much cash flow is needed in order to grow your business.
A common example is how long it takes the company to turn inventory into cash from sales.
CCC considers the length of time it takes to sell inventory, collect receivables, and pay associated costs. This tool helps to measure the company’s operations and management. Because it considers times, CCC is an important asset to measuring liquidity. Whereas static measures can be misleading because time is absent in their calculations.
To calculate CCC, follow this process:
CCC = Days of Inventory outstanding + days sales outstanding – days payables outstanding.
Cash Surplus/Deficiency Analysis
Asset deficiency occurs when a company’s liabilities are more than its assets. When this occurs, it is an indication that the company may be struggling with financial distress. It is also an indication that the company may be at risk of defaulting on its creditors’ financial obligations or beginning the bankruptcy process.
Asset deficiency is calculated: Assets – liabilities. Deficiency occurs when liabilities are higher than assets in value.
A cash surplus occurs when the amount of an asset or a specific resource is higher than the amount of that resource being utilized. A cash surplus specifically indicates that a company’s liabilities are well under their available asset value when converted to cash. This may be an indication that the company is appropriately balancing its finances.
To calculate a cash surplus, subtract liabilities from an asset’s value. A surplus exists when the cash required to operate the company (whether day-by-day or another timeframe) is more than the cost of doing so.
A quick ratio is a way of considering a company’s short-term liquidity. It helps to show just how easily a company can meet its short-term obligations on its liquid assets, and is a better representation over its more common ratio, the working capital ratio.
Quick ratio demonstrates that the company can quickly use its near-cash assets to pay down its existing liabilities, and manage short term business interruptions.
The formula for calculating the quick ratio is the following.
Cash and equivalents + marketable securities + accounts receivable / by current liabilities = quick ratio.
It is also possible to use a second formula:
Current assets – Inventory – Prepaid expenses / current liabilities = quick ratio
Working Capital Absorption
Liquidity can also be calculated with working capital absorption or working capital turnover. It measures how efficiently a business uses its working capital to directly support the growth and sales of the organization. More specifically, it measures the relationship between the money used to finance operations in a company and the revenues that are generated to continue the company and to create a profit.
The formula for working capital absorption is:
Net annual sales / average working capital = Working capital absorption
The net annual sales represent the gross sales after reducing it by returns, allowances, and discounts for a year. The average working capital is the average current assets for the company after reducing it by the average current liabilities.
Need Help Measuring Liquidity?
Measuring liquidity is a valuable step in managing the overall financial health of a company. It’s complex and often is something best left to a trusted accounting partner to handle. If you’ve already determined that liquidity isn’t what you would like it to be, or you want more information, seek a trusted company to support you. We’ll explain what liquidity is and why it’s important to your business.
Contact U-Nique Accounting today to learn more about the services we offer and how we work to support your company’s financial health.