Liquidity is a financial ratio, just like profitability and solvency. These ratios are used to understand the development of your business. Liquidity shows how well a company can meet its short-term payment obligations. So how flexible a company is financially.
Why is liquidity important?
Calculating liquidity is important to see if your company can meet its payment obligations properly. A lack of liquidity can get you into trouble as a business. The moment you are unable to meet short-term payment obligations, you run the risk that, for example, suppliers will no longer want to supply products.
How do you calculate liquidity?
When we talk about liquidity, there are two forms: static and dynamic liquidity. Static liquidity indicates whether your company can meet its payment obligations with current assets. Dynamic liquidity looks at the ratio of incoming and outgoing cash flows. To calculate liquidity, it is first important to know which form of liquidity you want to calculate.
Static liquidity is thus used to see whether the company meets its payment obligations with current assets. That is, the assets that can be monetised within a year. You can calculate static liquidity in several ways:
The quick ratio can be calculated using the following formula:
Quick ratio = Current assets / Short-term loan capital
If the outcome is higher than 1, you can immediately meet your payment obligations
Net profit capital
The net profit capital can be calculated using the following formula:
Net profit capital: Current assets – Short-term loan capital
With this calculation, you can see how much money remains after meeting your payment obligations.
The current ratio can be calculated using the following formula:
Current ratio: Current assets / Loan capital
If the result is higher than 1, you can meet your payment obligations. It is best if you have a value it between 1 and 2. If the current ratio is higher than 2, it might be wise to invest some of it in the business.
Static liquidity is mainly about the ‘now’ and dynamic liquidity looks mainly to the future. You do this by looking at the ratio of incoming and outgoing cash flows in a given period. For this, it is important to first make a liquidity budget and estimate what is actually happening with the cash flows. By comparing incoming and outgoing cash flows, you can see whether you can meet your payment obligations.
How do you improve liquidity?
To improve liquidity, it is good to first see if it is a structural problem or if it is a temporary problem because you have made an investment, for example. If it is a structural problem, you can start taking several steps:
Make sure you are not dependent on one customer
Maintain short payment terms of 30 days and send out timely reminders for payments
Work with a factoring company such as Factris to receive amounts earlier
Make personal contact with a customer if reminders do not help
Do not accept new orders from customers who do not pay their bills on time
Engage a collection agency in time in case of non-payment
Do you still have questions about liquidity or how to improve it with factoring? Feel free to contact us.