Liquidity

What it means

Liquidity is the ability to pay payables as they fall due. It is measured by ratios comparing current assets with short-term liabilities at three levels, according to how quickly the assets turn into cash.

The first level counts only cash and bank, the second adds receivables, the third inventory as well. The gaps between them show exactly where the company’s money is locked up.

The term is also used for individual assets: an asset is liquid if it can be turned into cash quickly and without a large loss of value. A term deposit or marketable securities are liquid, a specialised machine or a building is not, even though it may carry a much higher value in the balance sheet.

How it works in practice

For management a weekly cash flow outlook beats an annual ratio: it shows whether there will be enough on payday and for contributions. The ratios mostly serve conversations with the bank and comparison over time.

Liquidity improves with shorter payment terms on sales invoices, consistent collection, lower stock, and an agreed overdraft as a buffer. All of these act on working capital.

When a company applies for a working capital loan, the bank looks at the liquidity ratios in the latest financial statements and often writes them into the contract as a condition to be maintained. Before year end we therefore check with the client what the ratios will look like, so that a breach does not come as a surprise only when the statements reach the bank.

What to watch out for

A liquidity shortfall kills a company faster than a loss: a profitable business that cannot make payroll and contributions falls behind on priority liabilities, and enforcement is not far behind. So cash is planned ahead, not read off the balance in the morning.

A common mistake is paying for investments out of operating cash. Buying a car or machine outright from the account may save interest, but then there is no reserve left for VAT, tax advances and wages. Long-term assets are therefore financed from long-term sources, such as an investment loan or leasing, and cash stays with day-to-day operations.