Understanding liquidity is important so that you have a strong grasp about how easily your company can pay off short term liabilities or debts, and are able to judge market conditions based on the assets you own.
We’ve designed this no-nonsense guide to help you learn the ins and outs of liquidity in accounting.
Liquidity is a measure of how easily an asset can be exchanged. In essence, liquidity means how quickly an asset can be turned into cash or how near the asset is to cash.
Cash and stocks typically have high liquidity because they are easy to access and trade. In contrast, tangible assets like real estate, fine art and other valuable collectibles are often illiquid. Other financial assets such as equities or partnership units usually vary on the liquidity spectrum.
Importantly, liquidity management investors or managers work to reduce liquidity risk exposure. Managing liquidity is the true cornerstone of every treasury and finance department, and is the most basic means of a company’s access to readily available cash to fund short-term investments, pay debts or cover the costs of goods & services.
Follow these steps to understand how to improve liquidity in your organisation:
- Eliminate unproductive assets. Get rid of costs on assets such as buildings, equipment and vehicles that provide little or no value for your organisation.
- Monitor accounts receivables effectively. In short, make sure that you're billing your clients properly and that you're receiving your payments in good time.
- Adjust your accounts payable. Try negotiating longer payment terms with your vendors if possible so that you can keep hold of your money for longer.
- Make use of “sweep accounts” through your financial institution. Sweep accounts allow you to earn interest on any excess cash balances by transferring your funds into an interest-bearing account when your funds aren't needed, and then sweeping the funds back into your operating account when you need them.
- Assess your overhead costs and look for opportunities cut back. This will have a direct impact on the profitability of your organisation. Re-evaluate your overhead expenses such as: indirect labour, rent prices and professional fees.
- Review the profitability of product and service offerings. Make a measured judgement where prices can be increased on a regular basis to potentially increase profitability. As your costs increase and the markets evolve, the prices you charge may need to be changed.
How to Manage Liquidity Challenges From COVID-19 Disruptions
As a result of the COVID-19 pandemic, companies across the globe are either anticipating or currently experiencing constraints on cash and working capital — ultimately causing liquidity challenges.
To combat the challenges presented by the virus, organisations must test all incoming and outgoing cash flows. To do this effectively, it’s important to model the worst-case scenarios to properly measure the financial impact in a measured way. Consider:
- Establishing a short-term cash flow forecast
- Running multiple scenarios and preparing for those outcomes.
- Taking actions to protect your financial position.
- Understanding the minimum cash and liquidity requirements of your organisation.
- Setting up a central point of control and communications for your team.
- Developing contingency plans that ensure your accounting operations continue.
What Does Liquidity Mean in Accounting?
Liquidity in accounting measures the ease at which a company can meet their financial obligations based on the liquid assets they own or are available to them. Basically, the ability to pay off dues as they are due.
When considered in terms of investment, liquidity in accounting involves comparing liquid assets alongside current liabilities or financial obligations due within one year. Analysts and investors use liquidity ratios to measure accounting liquidity which vary depending on how strictly they define a “liquid asset”.
What are Liquid Assets in Accounting?
Liquid assets are arranged and presented on a balance sheet according to the amount of time it takes to convert them into cash. Assets typically fall into the following categories:
- Cash
- Marketable securities
- Accounts receivable
- Inventory
- Fixed assets
- Illiquid assets (that cannot be converted to cash until the company is sold)
What is a Liquidity Ratio in Accounting?
To measure liquidity accountants use liquidity ratios. The three most common accounting liquidity ratios include:
Quick Ratio
The purpose of this ratio is to measure your business’s ability to pay off your liabilities, with quick assets that can be converted to cash within a 90 day period. Quick assets are typically: cash equivalents and marketable securities.
Formula for the quick ratio:
Quick Ratio = Cash + Cash Equivalents + Marketable Securities + Accounts Receivable
Current ratio
Considered as the simplest liquidity ratio in accounting, this ratio measures your company’s current assets against current liabilities. The current ratio is different from the quick ratio because it excludes assets that cannot be liquidated quickly.
Formula for the current ratio:
Current Ratio = Current Assets / Current Liabilities
Cash ratio
The cash ratio excludes inventories, accounts receivable, as well as other current assets by only considering liquid assets as cash or cash equivalents. The cash ratio is the best formula if you have to identify your company’s ability to remain solvent during a time of crisis or emergency
Formula for the cash ratio:
Cash Ratio = (Cash + Cash Equivalents + Short-Term Investments) / Current Liabilities
Prepare Your Firm For the Future with INAA
We’re the International Association of Independent Accounting firms, established over 25 years ago to facilitate cross-border business.
Here at INAA, we connect accounting firms who aim to deliver quality professional services around a shared vision to make global business personal and take personal business global. Our collaborative association of international businesses is committed to being a part of the conversation around accountancy.
Join today to start building powerful business relationships.