Why Should Small Businesses Focus on Liquidity Management?

Making a profit is certainly the main objective of every business out there, but one of the more important factors people tend to forget about is liquidity.

Lack of profits can kill your business in just a few months. However, lack of liquidity, can destroy your whole organization basically in a heartbeat.

Actually, according to the best-selling author and business adviser, David Mellor, lack of liquidity is the second biggest reason why small businesses fail in the United States.

What is liquidity actually?

If you’re new to all of this “business lingo” you’re probably wondering what liquidity even is. In essence, it’s a term used to describe an asset categorized by how fast you can trade it on the open market, without affecting its value.

For instance, cash is a liquid asset. You can trade it for other goods on the market without its price being changed in the process. When you want to buy something – a car, a new home or office supplies – cash will certainly do the trick.

Cash aside, even if you have something valuable, like vintage furniture, jewelry, etc. you technically still have liquidity. However, since the price of those assets varies – some people lower the price to sell their assets quicker, for example – they are relatively liquid.

When it comes to your company, the most important thing is that you have enough assets to pay your debts on time. In most cases, this depends on how much cash you have available, in comparison to the liabilities of your company.

Why is it so important?

As we indicated before, on the surface level, it’s all about the profit. But your enormous profit margin doesn’t actually mean too much if you’re not able to pay off your current debts and use the rest of your funds to invest in your business and keep it afloat.

Having cash at your disposal gives you the freedom to make an investment and expand your business, when the right opportunity comes up. And no matter how unlikely it seems, you never know when a financial crisis may occur, so having some cash stashed away is almost a type of insurance.

In order to keep up with your liquidity, you need to track your liquidity ratio. Here are three most commonly tracked ratios among small business owners:

  • Current ratio

More commonly known as “working capital ratio” this ratio measures your liquidity by comparing assets to liabilities. If your company has a current ratio of 2:1, most financial experts would agree that you have a “financially healthy” company on your hands.  

  • Quick ratio

This ratio is used to evaluate your organization’s capacity to fulfill its promises. Some companies track quick ratio on a monthly basis, in order to identify negative trends and make some adjustments that will help them satisfy debt requirements in the future.

  • Operating cash flow ratio

If you want to measure operating cash flow ratio, you just need to add up all the cash taken from your operations and divide that value by your current liabilities. This ratio is used to assess whether your current cash flow is sufficient to cover your debts.

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How to increase your liquidity?

  • Finance through factoring

In this case, a “factor” is actually a financing firm that offers to pay out your accounts for a price. Essentially, these companies pay up front what your customer is due and take a percentage. If you have to pay a few invoices and you need the cash right away, this is a rather convenient option.

  • Taking a personal loan

This is perhaps the simplest way of increasing cash flow through your company. Of course, you have to be careful with loans and wait for the right moment to take it. In most cases, taking personal cash loans is the smartest option if you want to correct the liquidity of your business instantly.

  • Minimizing liabilities

If you don’t want to increase your cash flow, you can take the other route, and reduce the amount of money coming out of your organization. Some people simply have too much inventory lying around the office, and this can decrease your liquidity drastically. Therefore, you need to have a good strategy to make sure that your inventory is always ready to be sent out and sold.

Don’t get too comfy if your profits go up

When you’re dealing with liquidity, you have to be calm and calculated at all times. Simply put, you can’t let yourself get distracted by other, less important aspects of running a business.

Moreover, we should also point out that you can’t get too comfortable when your profits start going up. On the contrary, you always have to be aware of how much money you and your company earned is at your disposal.

Without knowing that, your business venture might fail without any particular warning signs when you and your partners expect it the least.

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