Liquidity is a key figure and shows a company’s availability of cash and cash equivalents in relation to current liabilities.
What is liquidity and what does it mean?
Liquidity is a financial measure and measures the business’s ability to pay bills and other expenses and is often used to show a company’s ability to pay in the short term. It is crucial for a company’s survival that they have sufficient financial resources to manage their payments.
The assets that a company has directly available, ie. money that can be used immediately, is called cash. Cash and cash equivalents are the money that is available as cash in the company’s cash register, as well as in the company’s various accounts. Shares and bonds are not counted as a company’s cash and cash equivalents.
A person or a company can be liquid or illiquid
Good liquidity is required to be able to pay off its current liabilities. A company or a person who has the opportunity to pay their debts on time is referred to as payment.
Illiquid is called a company or a person who has ended up in the opposite situation, ie. when a person or a company does not have the ability to pay in the short term.
Poor liquidity can lead to a company having problems paying its running costs, such as bills.
Good liquidity generally means many benefits
A company is expected to maintain liquidity that is high enough for the business to continue to be conducted, but not so high that it slows down returns.
High liquidity often provides greater security for the company to manage its payments and commitments.
A high level of liquidity also acts as a buffer to reduce the risk in unexpected situations that could affect the company’s finances.
Excessive liquidity, on the other hand, can be unfavorable because this money is not remunerated in the best way, or not at all.
There are different ways for companies to release capital, ie. increase liquidity. Liquidity can be increased, for example, with the help of good profitability, increased borrowing, contributions from the owners (new issues, etc.), a reduction in inventories and the sale of fixed assets.
How is liquidity calculated?
1. Cash liquidity
Cash liquidity is a key figure that is usually used to show a company’s ability to pay in the short term. Cash and cash equivalents are cash and cash equivalents as a proportion of current liabilities.
A rule of thumb is that cash liquidity should be greater than 1 (or at least 100 percent), which means that the cash and cash equivalents are equal to, or greater than, the current liabilities.
Cash liquidity is calculated according to the following formula:
Cash liquidity = Current assets excluding inventories and work in progress ÷ Current liabilities
2. Balance sheet liquidity
The balance sheet liquidity shows, just like the cash liquidity, a company’s short-term ability to pay. The difference between the two concepts is that the company’s inventories are included in the measure of balance sheet liquidity, which it does not in the measure of cash liquidity.
Balance sheet liquidity is therefore relevant for companies with slightly more extensive “inventory operations”, such as companies in retail and wholesale.
A rule of thumb is that balance sheet liquidity should be greater than 2 (or at least 200 percent).
Balance sheet liquidity = Current assets ÷ Current liabilities
How much liquidity is adequate?
For companies, it is important to keep a good balance when it comes to liquidity. The company must have sufficient liquidity to pay current costs and keep the business going.
If not, problems arise immediately, as employees tend to stop working if they do not receive their salary. In the same way, there can be problems with deliveries if the suppliers do not get paid.
Good liquidity also acts as a buffer that minimizes the risk of the company ending up in unexpected situations where you can not pay your debts or anything else that can affect the company negatively.
But it can also be too much of a good thing.
With too much liquidity, the company does not use its money in an optimal way because an unnecessary amount of assets just lies and litter on accounts where they do not earn interest.
A well-run company should have good liquidity.
But it is also expected to either reinvest the surplus in the business, invest the money elsewhere or set it aside for dividends to shareholders.
Improve their liquidity
It is possible to improve liquidity in several ways. For example, a company can raise cash and thereby improve its liquidity by selling assets, reducing costs and improving profitability.
Other alternatives are to borrow money, ask for capital contributions from the owners, issue new shares (new issue), sell any inventory or other valuable assets.
If liquidity needs to be improved quickly, factoring, ie selling unpaid customer invoices, can also be an option. A private person who wants to improve their liquidity (for example to be able to take out a mortgage or larger private loan) has fewer alternatives.
You can, for example, sell assets such as shares, capital goods or in some way increase your income.
There are basically two things you can do as a private person to improve your liquidity in a short amount of time. Increase your income or reduce your expenses.
A first step to take control of the situation can be to establish a household budget, then you will quickly see what expenses you can reduce.
If you have several debts, a restart loan can be a smart alternative.
With a start-up loan, you collect expensive credits in a large loan. In this way, you often get a lower interest rate, which lowers your fixed costs.
Which in turn means you get more money to move around with.
Most companies (above a certain size) work continuously with liquidity forecasts in order to be able to predict the need and flow of liquid funds.
Poor liquidity is something you want to avoid at all costs. With poor liquidity, it becomes difficult to pay invoices, interest on loans and, in the worst case, salaries.
Failure to pay on time quickly leads to extra costs and reduces the company’s confidence.
If you have poor liquidity for a long time, the company’s entire future can be jeopardized. For this reason, it is common for companies to also draw up one (or more) liquidity budget.
The liquidity budget is a plan that determines how much money the company must have available in its accounts or in cash to pay current debts.
Liquidity in different types of companies
Having good liquidity means that the company can be run without a halt in delivery or a break due to liquidity problems.
Companies with good liquidity have no problems paying their debts and can easily run their business without worrying about stopping.
At the same time, the good liquidity means that the company has a lot of money that just lies around littering without doing any good.
The money is not remunerated and any investors may even point out that the company is unwilling to invest. It is therefore important to find a good balance.
What is a good balance depends a lot on the type of business the company conducts and where you are in the development.
Companies that have been around for a long time are expected to be more liquid than start-ups. Conversely, it is common for startup companies (on paper) to have liquidity problems, as they generally have little capital but often great opportunities to grow and quickly increase their revenues.
In the case of a start-up company, investors can therefore often accept liquidity that has been a problem in an older company.
They simply expect that money will start to roll into the newly started company later on.
However, it should be remembered that there is always a greater risk of investing money in a company with poor liquidity, but this does not have to be a sign that the company is mismanaged or doing poorly when it comes to a startup.
Liquidity in financial markets
Liquidity can also describe how well a financial market works. Liquidity is then a measure of how large a supply there is of a certain type of assets and how quickly they can be turned over, ie converted into money.
The market can refer to, for example, real estate but also various forms of securities or other financial assets. A liquid market is a market where there is a large supply and sales are high.
For example, there are many properties for sale but also many potential buyers, which means that many deals are made.
Conversely, in an illiquid market there are few goods for sale and even few buyers. It is difficult with others or takes a long time to find both buyers and sellers.
The market thus does not grow but stands still or declines.
The most liquid market is unsurprisingly the market for cash, ie national currencies. Cash is the most liquid asset of all because there is always a demand for them and they are a direct means of payment.
However, different national currencies have different degrees of liquidity. For example, a smaller currency such as the Swedish krona is less liquid than the US dollar.
High and low liquidity affect the risk
Having “low liquidity” as a company means that it can be difficult to pay interest and invoices. Not being able to pay on time means a risk to the company’s future.
To reduce the risk of ending up in a difficult situation, you can make a liquidity budget. A liquidity budget is a plan that shows how much money you must have at the cash register or at the bank to be able to pay your debts.
A “high liquidity” provides increased security because the person or company is expected to be able to fulfill their obligations and pay their invoices on time.
This means that the player is expected to survive in the short and long term.
It is often said that in order to be able to cover short-term liabilities, cash liquidity must be 100 percent.
Cash liquidity = current assets excluding inventories or early payments / current liabilities.
Sometimes the balance sheet liquidity is calculated. It should be 200 percent or more. The formula for it is current assets / current liabilities.