What is the liquidity of a company?

picture of the writer Hendrik Keeris, Co-Founder Bizzy

Hendrik Keeris, Co-Founder Bizzy

7/1/2022

How to?

what-is-the-liquidity-of-a-company

Alongside profitability and solvency, liquidity is an important indicator when analysing the financial performance of a company. Liquidity indicates whether the company can generate enough cash in the short term to pay its short-term debts or payment obligations. 

The company can either have enough cash on hand or it must generate enough cash. The latter happens when customers pay or when the company sells assets such as financial stocks, inventories or even buildings. The important thing here is to look at how quickly that cash can be generated. Cash is cash so you have that immediately. Customers pay within 90 days, so you have that pretty quickly. Selling inventories, on the other hand, if it is sellable at all, can take more time. Selling fixed assets like buildings takes even longer, so you can't really count on that to pay off short-term debts. 

In short, when you check the liquidity of a company, you have to look at what the company has in the short term (current assets) and whether that is enough to compensate for what the company owes in the short term (current liabilities).

How can you assess the liquidity of a company?

Current ratio

The current ratio is a first general ratio to assess the liquidity of a company. It is calculated by dividing current assets (trade receivables, marketable securities, inventories and cash) by current liabilities (short-term liabilities such as trade payables or short-term financial debts). In general, the current ratio should be greater than 1, meaning that the cash the company can generate in the short term is greater than the cash it owes in the short term. Of course, this should always be looked at in context and a current ratio less than 1 is not necessarily alarming.

Current ratio = current assets/current liabilities

Quick ratio

The quick ratio, also called the acid test, is equal to the current ratio with the exception of the inventories. In the quick ratio, the inventories are not included under the current assets with the idea that they are not so easy to convert into cash. The quick ratio is also ideally greater than 1 with the same nuance that everything must be viewed in its context.

Quick ratio = (current assets - inventories)/current liabilities

Net working capital vs. Net working capital requirement

A good way to assess a company's liquidity is to compare its net working capital with its net working capital requirement. 

A company's net working capital is the difference between its current assets (such as cash, trade receivables or inventories of raw materials or finished goods) and current liabilities (such as trade payables, wages to be paid or other short-term debts). For example, net working capital will be positive if the company has to receive more money through trade receivables than it owes to suppliers.

In addition, a company has a net working capital requirement. This arises from the fact that the purchase of raw materials, goods or services, which involves a cash expenditure, takes place before the company can sell its goods or services, which involves a cash income. The company therefore needs cash to finance these initial expenditures and to bridge this period. This financing must be done by the net working capital. In other words, the difference between current assets and current liabilities must be large enough to cover the period between cash expenditure and cash income resulting from day-to-day operations.

Take the example of a producer of dried ham. The producer must first purchase and process the meat, which involves a cash expenditure. The ham then has to dry for a long time before it can be sold to the supermarket, and once it is in the supermarket, the supermarket only pays for it after 90 days. So the period between the cash expenditure when the ham is purchased and the cash income when it is paid by the supermarket must be bridged with additional cash. In other words, the net working capital requirement must be covered by the net working capital.

However, too much working capital is not good either. It can mean that too much cash is tied up in, for example, too much inventory. That cash could be used elsewhere to invest in further growth, it could earn interest in the bank or it could provide a financial return by investing in financial instruments such as shares or bonds.

How can you improve your own liquidity?

  • Try to negotiate a longer payment period with suppliers and pay as late as possible.

  • Make sure that customers pay faster. This can be done by shortening the payment term on your invoices.

  • Send your invoices, payment reminders and reminder letters as quickly as possible.

  • Make sure you have good inventory management to keep your inventory as low as possible, because buying inventory requires cash before you have sold anything.

  • Have your outstanding invoices paid by a factoring company. They pay you directly and will ask for the money from your customers for a small percentage fee.

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