Many small businesses close because they were unable to pay their bills. They were unaware that their company was not liquid. To put it into accounting terms, liquidity measures the financial capability of your small business to settle current liabilities with cash or other current assets.
Current liabilities include bills, payables, short-term loans, taxes and other short-term liabilities that your company must pay within 12 months. Current assets are cash or assets you can quickly turn into cash, inventory, accounts receivables, and marketable securities. If you fail to remain liquid, you might end up going through the process of small business liquidation.
How can you assess your small business’ liquidity?
One way to assess your company’s liquidity is to use financial ratios. The ones you should know are:
- Current Ratio – you get the current ratio by dividing your current assets with current liabilities. The ideal ratio is above one because it means you have enough current assets to pay current liabilities. However, there are instances when this isn’t always the case. If the current ratio is less than one, a small business may just be good at maintaining low inventory.
- Acid Test Ratio – this is similar to the current ratio, but it doesn’t include inventory in its calculation. You get this number by dividing the total of the accounts receivable, marketable securities and cash equivalents with your current liabilities. Inventory varies in various industries that’s why some experts say that the acid test ratio provides you with a clearer picture of your liquidity. However, if you have a ratio of less than one it may either mean you have a liquidity problem or your company is able to collect accounts receivables in a timely manner.
- Cash Ratio – this liquidity ratio takes a conservative computation wherein you divide the total of marketable securities and cash equivalents with current liabilities. A high cash ratio means you have more than enough cash to settle current liabilities.
How can you improve liquidity?
Cash is king so the more you have of it the better your liquidity will be. Find ways to increase sales to generate revenue you can use to pay current liabilities. Try to reduce operational costs to keep your profit high and maintain liquidity. Sell equipment while they still have value and consider outsourcing some tasks to cut costs. Improve your receivables collection by implementing penalties for late payments and shorten the period for payment. These allow you to avoid small business liquidation and keep your company going.
If you need help with bookkeeping, you can reach out to us. We at Robookkeeper can provide you with quality accounting services for small business owners.