Liquidity refers to the ability to turn your assets such as investments, accounts receivable, and inventory into cash. What assets does your business have that you can cash in today for their full value?
Low liquidity asset may be hard to sell for their true values when you're facing the pressure of an inventory shortage before the holidays. Explore the following three reasons why having liquidity is important for your business.
You want financing and credit
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You may wonder, “Is my liquidity ratio really that important to my small business?” It definitely is if you want to borrow money. A small business's liquidity ratio tells potential creditors and investors that your company is strong, stable, and most importantly, has enough assets stockpiled to weather any storm.
Many small business owners consider a working capital loan from an online lender to offer a stopgap through the rough times. Loans and financing can enable small businesses to pay off creditors, buy inventory, and cover payroll during off-season periods. While some small business owners may worry about whether taking out a loan is too risky, there are plenty of ways to ensure that you're able to keep up with your loan payments. Just make sure you do your research ahead of time and never take out a loan for more than what you really need.
To calculate your small business's liquidity ratio, divide your assets by your current liabilities. Lenders are generally looking for a number somewhere between 1.5 and 3.
You need a guide to making smart decisions
Regularly monitoring your company's liquidity ratio ensures sound, informed decisions that will increase your company's profits and drive growth. And that's why we're here, right?
Does your company have too much liquidity? Consider expanding or improving your business, but avoid the temptation to go on a spending spree that isn't in line with your business's strategic plan. The idea is to avoid idle cash that's not being used efficiently.
A low liquidity ratio says your company may be suffering financially and that your business is on the road to economic stress. Low ratios help spot trouble ahead, so you can jump in and liquidate some assets before it's too late. One missed payment can mean your company's good credit history and short-sightedness can miss hurdles in the future.
Don't stop with analyzing your own business's current ratios; look at your competitor's ratios, too. By doing so and setting your sights ahead, you'll be able to spot potential opportunities in your business's economic future.
You need liquidity in case of an emergency
Joshua Kennon, managing director of Kennon-Green & Co., advised, “Remember one important lesson: At least some portion of your net worth should be kept in liquid assets. That liquid portion has one primary job, and that job is to be there when you reach for it.”
A 2016 U.S. Bank Small Business Annual Survey (May 2016) revealed that 31 percent of business owners still feel like the United States is in a recession, making liquidity of your assets as important as it was in 2008. Many financial planners recommend at least a month or two — if not six months — of cash on hand in case of an emergency.
To increase your company's liquidity, consider what your business has that sells quickly when cash is short. Stocks liquidated, accounts receivables collected, inventory sold, and unused supplies returned to vendors are all ways to boost cash. Have a plan on hand before adversity comes knocking.
Take the time to make informed decisions about your company's spending and borrowing by carefully monitoring liquidity in your business. Know your ratios and look for a variety of prospects that generate cash. Consider financing when needed; careful planning leads to company growth and profits.