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.
As a seasoned financial expert with a deep understanding of corporate finance, liquidity ratios, and the intricacies of financial health assessments, I can attest to the critical role that liquidity plays in determining the robustness of a company's financial position. My extensive experience in the field, combined with a comprehensive grasp of financial concepts, allows me to shed light on the key takeaways and recommendations presented in the article.
The article primarily emphasizes the significance of maintaining a strong liquidity ratio for businesses. It rightly points out that while a steady cash flow is vital, liquidity ratios offer a more nuanced perspective on a company's ability to meet its existing debts with available assets. I appreciate the article's distinction between current ratios, quick ratios, and cash ratios, as these provide varying levels of insight into a company's liquidity.
The concept of liquidity ratios, as mentioned in the article, involves assessing the accessibility of assets in different scenarios. Cash is identified as the most liquid asset due to its immediate accessibility. The article explains that a higher liquidity ratio makes a business more appealing to lenders and investors, essential factors for sustainable growth.
Furthermore, the article introduces three key liquidity ratios:
- Current Ratio: Compares all current assets to current obligations.
- Quick Ratio: Considers only assets that can be accessed quickly.
- Cash Ratio: Focuses narrowly on cash and cash equivalents.
The calculation of these ratios involves dividing the respective assets (current, quick, or cash) by business liabilities. This method provides a quantitative measure that lenders and investors use to evaluate a company's financial health.
The article also outlines what these numbers signify:
- Healthy Current Ratio: A ratio of 1.0 or higher indicates that a company can meet short-term demands and has enough cash for investment or expansion.
- High Current Ratio: A ratio higher than 1.0 may suggest excessive cash holdings that could be better utilized.
- Low Current Ratio: A ratio below 1.0 signals potential difficulties in meeting short-term obligations, posing a higher risk to lenders and investors.
For business owners seeking to enhance their liquidity ratios, the article provides practical strategies:
- Control Overhead Expenses: Negotiate and shop around for reduced expenses.
- Sell Unnecessary Assets: Liquidate surplus business equipment to generate capital.
- Change Payment Cycle: Negotiate discounts with vendors for early payments or offer customer incentives for early payments.
- Consider a Line of Credit: Utilize a line of credit to cover cash flow gaps.
- Revisit Debt Obligations: Assess and potentially switch between short-term and long-term debt based on business needs.
In conclusion, the article serves as a valuable resource for business owners, offering actionable insights into maintaining and improving liquidity ratios, ultimately contributing to a healthier financial profile.
