Proper accounting is like engineering. You need a margin of safety. Thank God we don't design bridges and airplanes the way we do accounting. - Charlie Munger
What are liquidity ratios?
They measure a business’s ability to pay its current obligations in a timely manner without the use of outside capital or funding. They can also be thought of as a cushion that could be used to battle difficult economic times, negative events specific to a company (e.g. loss of a major client), or to expand.
Why do I need to understand liquidity ratios?
Small business owners need to understand liquidity ratios in order to position themself to have sufficient working capital deal with the possible events described above. Lenders use liquidity ratios when making decisions about whether or not extend credit or loans. Knowing what your small business’s liquidity ratios before approaching a lender will help you understand, first whether they would extend credit in the first place and second illustrate to the lender that you are a savvy entrepreneur.
What are the different types of liquidity ratios?
Current ratio – Measures a business’s ability to pay its current liabilities (due within 12 months) with current assets, like cash, accounts receivable, inventory, and other assets that can be converted to cash within 12 months.
Quick ratio – Measures a business’s ability to pay its current liabilities with its current assets less inventory. This ratio is more conservative and assumes that the business will not be able to convert inventory to cash within 12 months.
Cash ratio – Measures a business’s ability to pay its current liabilities with only its available cash. This ratio is most conservative and assumes that the business will not be able to convert inventory, accounts receivable or other current assets to cash within 12 months.
Net working capital – Measures a business’s liquidity in terms and financial strength (or weakness) in terms of dollars. This is calculated by taking current assets less current liabilities. This dollar value represents the cushion (or lack thereof) a small business has to deal with challenges or expand its business.
Operating cash flow ratio – Measures a business’s ability to generate sufficient operating cash flows to pay its current liabilities. This ratio and the current, quick and cash ratios all measure a business’s ability to pay current liabilities; however, the operating cash flow ratio assumes cash flow from operations will be used to pay current liabilities.
Do you know what your business’s liquidity ratios are?
For most small business owners, liquidity ratios provide insights into the financial health of their businesses. Knowing what yours are now can help you determine whether or not it is a good time to apply for a loan or line of credit or wait so that you can take steps to better position the business for the future.