As we’ve seen in the last year or so since the start of the global pandemic, anything and everything can happen, so it’s best to keep our books in order and ready to withstand the unexpected. We’ve previously published a primer on essential finance terms every CFO should know. Today, we’re zooming in to talk about assets, liquidity and why it’s important.
What is liquidity?
Liquidity refers to the ease with which you can convert an asset into cash without affecting its market price, or in other words, value, too much.
When we talk about liquidity, these are the two broad categories:
- Market liquidity
- Accounting liquidity
Market liquidity has to do with the liquidity of a market, such as the real estate market or stock market. It refers to these markets’ ability to allow assets to be bought and sold at stable prices.
When it comes to accounting, liquidity refers to the ease with which you can convert assets and investments that your company owns into cash, for as much of their full value as possible. In other words, it refers to how readily your company can sell off assets to cover short-term financial obligations as and when they arise.
How is financial liquidity measured?
When measuring liquidity, a ratio greater than one is considered a good indicator of healthy liquidity. There are three main types of liquidity ratios:
- Current Ratio
- Acid test ratio
- Cash ratio
The current ratio measures your current assets against your current liabilities. It is an indicator of your company’s ability to repay debts. The higher your ratio, the more capable your business is to pay off short term debts. Let’s calculate ratios of a fictional eCommerce startup called ShopParadise. ShopParadise’s current ratio would look something like this:
= $4,800 cash + $1,000 inventory + $1200 accounts receivable from customers
= $1,000 accrued company expenses + $1500 accounts payable
= Current assets / Current liabilities
= $7000 / $ 2,500
What this means: ShopParadise has $2.80 for every $1 in liabilities.
Quick Ratio (or “Acid test ratio”)
The quick ratio is a step more conservative than the current ratio. It measures your company’s ability to pay off short term obligations with only your most liquid assets. This means that it eliminates the current asset that is most difficult to turn into cash. In the fictitious case of ShopParadise, that would be the inventory. Here’s how the ratio is calculated:
Acid test ratio = (current assets – inventory) / Current liability
The cash ratio defines liquid assets most strictly, to include only cash or cash equivalents. This ratio assesses your company’s ability to stay solvent during emergencies. Its formula is:
Cash ratio = (cash + cash equivalents) / current liabilities
Reading the Balance Sheet
In order to measure this, your accounting team has to calculate the ratio from information on your balance sheet. Your company’s balance sheet shows what you own and owe, and how much shareholders have invested.
A balance sheet is an important tool your organisation’s executives and finance team can use to understand the financial health of your business because it provides an overview of your assets and liabilities, allowing you to see the net worth of your company at the moment.
*Image Source: Investopedia
On the balance sheet, your assets are listed in order of their liquidity. You will find them divided into current, liquid assets (assets you can liquidate within one year or less) and long-term assets.
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What are Liquid Assets?
Assets broadly fall into two categories, liquid and illiquid assets.
Defining liquid assets
A liquid asset refers to a type of asset that you can convert into cash easily while keeping its market value. In order for an asset to be considered a liquid asset, it has to meet these criteria:
- Ownership of the asset has to be easily and quickly transferable to the buying party
- It has to be in an established market, with a lot of interested buyers
What are examples of liquid assets?
Liquid assets can be cash or other instruments that can be quickly, effectively converted to cash.
Cash is considered a liquid asset because of how easy it is to be accessed quickly. Cash is legal tender that a startup could use to pay off financial obligations due within the current financial year (also otherwise referred to as current liabilities). For example, you could readily withdraw money in your high interest rate savings account or multi-currency account to use it to settle outstanding financial liabilities.
Accounts receivable, or, the money owed to your company by consumers, also count as liquid assets. Prepaid insurance and demand deposits too.
Other liquid assets include marketable securities such as your stocks (and your cryptocurrency coins too, if you’re into that), bonds, and money market funds. While these assets can be sold (i.e. liquidated) at short notice, these other assets are further down the liquidity ladder than cash because they can potentially be sold below value if we’re in a bear market.
What are examples of non-liquid assets?
On the other hand, we have non-liquid assets, also called fixed assets, such as collectible items like jewelry, art, watches and handbags, as well as cars and real estate. These assets are difficult to liquidate quickly. It would take a long time for you to sell these items in order to convert them into cash, and the cash obtained from their transactions may also be lower than market values of the assets.
For example, you might end up selling your car or gold bracelet at a much lower price point than when you bought it. Depending on the property market, a company looking to sell their commercial building may not only take months because of the long process of listing, having viewings, and negotiation, but may also fail to fetch a profit if it happens to be a buyer’s market or recession at that present moment.
In a situation where you have sudden, unexpected debt obligations that need to be paid soon, you would have to sell assets with greater liquidity than these.
Why is it important to have liquid assets?
From a business standpoint, greater liquidity means greater accessible funds. For startups, this means having the potential to free up extra funds to help with scaling the business.
As a business owner, your liquidity of assets matter because it is an indicator of how prepared your company is to weather unforeseen economic changes and emergencies, such as the most recent COVID19 pandemic that shook the world. These assets are your contingency plans for rainy days and help to maintain financial stability in these times.
Additionally, it’s also good for your credit score. Having more liquidity also means being more positively assessed by financial institutions for when you want better loan terms and interest rates (always a good thing for startups and scaleups!).
Should you prioritize liquid assets over fixed assets?
In a volatile and changing global environment, it’s important to prioritize building up your company’s liquidity ability to weather storms.
Just like how personal finance experts recommend building an emergency fund of at least six months in your bank account to cover unexpected expenses, from a business perspective, it’s important to start building up your liquid assets to cushion against the potential expenses and unexpected liabilities your company might face.
Figuring out how much requires taking into consideration your current operating costs, salary payments to employees, and other bills. Only once your emergency funds are looking healthy should you start spending more time considering other ways to grow your company’s worth beyond liquid assets.
What can companies do to maintain healthy liquidity especially during a pandemic?
Understanding the difference between Operating costs VS Overhead costs
According to Investopedia, operating costs are expenses your business incurs as a result of normal operations, such as labour, machinery, and materials. Operating expenses are required to keep your company running, and cannot really be omitted.
On the other hand, overhead costs refer to what it costs to run your business. These include rent, insurance, and utilities. These costs can and should be reviewed often by your executive team to identify ways to increase profitability.
Overhead costs you can cut to improve liquidity include:
Office Space: A commercial office space rent often takes up a sizable portion of overhead costs. Over the past year, as a big part of workforces worldwide adapted to COVID19 challenges, more people have taken to the hybrid work model of remote working and occasional real-life interfacing with each other. If your company has enthusiastically embraced a remote work policy, you could consider downsizing your office to a smaller space that accommodates up to 70% of your workforce as it would be unlikely everyone returns to work on the same day. Operations team members can then draw up a roster planning office returns to ensure no overcrowding.
Alternatively, completely giving up a permanent office space and moving to a fully remote workforce is also a viable option. You can complement this with signing up for a coworking space plan, such as renting a WeWork space twice monthly for all employees to meet up and work together.
Marketing budgets: If your startup allocates a significant portion of your monthly spend to paid advertising to build brand awareness, consider incorporating more low-cost organic growth marketing strategies and cutting paid spend.
Get rid of unnecessary costs
Find a corporate card that has low-interest rates and fees: In times of recession, cutting down on unnecessary ‘hidden costs’ such as payment fees should be done.
Additionally, consider improving your invoice collection. Finding the right software for tracking payments and sending accurate invoices helps to ensure smooth cash flow for your company.
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