Liquidity describes how quickly you can sell an asset and convert it into cash.
Liquidity can:
- Affect your credit score and how much you can borrow.
- Measure whether you can pay your bills on time.
- Reflect the overall financial health of your business.
While liquidity is important, its relevance varies based on industry. Real estate is a good example. AT LCW CPAs, we work with many business owners in the real estate sector. Real estate is not extremely liquid because typically it can take months for property to be transferred from one owner to another. If your business sells items that take a long time to produce, liquidity can be challenging and should be measured and managed. Other industries that are not liquid include farms, wineries, breweries, automobile manufacturers, and biotech research.
Liquidity Ratios: Current Ratio and Quick Ratio
At LCW CPAs, we use two primary financial metrics to quantify your business’ liquidity: current ratio and quick ratio.
The current ratio reflects the financial health of your company at any given time.
Current Ratio = Current Assets / Current Liabilities
Current assets include cash, cash equivalents, accounts receivable, and any other asset that can be converted to cash within one year.
Current liabilities include credit card balances, accounts payable, bills due, interest payable, and the amount of any loan due within one year. Both current assets and current liabilities are reflected on your balance sheet.
Companies with a current ratio of less than 2:1 are considered less liquid, while companies with a current ratio of more than 2:1 are more liquid.
The quick ratio is another measure of liquidity. This ratio measures how equipped your business is to meet its short-term obligations. The formula for the quick ratio is as follows:
Quick Ratio = (Cash + Cash Equivalents + Accounts Receivable) / Current Liabilities
The goal of the quick ratio is to take the most liquid assets, cash equivalents, and use them to pay down current debt that your business has. This ratio’s value should typically be 1:1.
Both current ratio and quick ratio are productive ways to evaluate the liquidity of your business. At LCW CPAs, our team of professionals are educated in a variety of industries including restaurants, construction, manufacturing, and more. Please contact us and learn more about how we can help manage your business based on your current liquidity ratios.
The Importance of an Emergency Fund and Three Steps to Build One
At LCW CPAs, we recommend building a healthy emergency fund. Just as households should have an emergency fund to cover many months of expenses, a business should also have an emergency fund to have in the event of a business emergency.
- The first step in creating an emergency fund is to determine how much you typically spend each month. This number can be found by reviewing past bank statements and summing all the withdrawals including checks paid and online withdrawals. At this step it is crucial to follow the same process with each bank account you have and include any other accounts such as PayPal if you use them for disbursements. When this step is complete, your will know how much your business spends per month.
- Next, we advise our clients to review bank statements from a few months back and calculate their average spending per month. The more months you include in this calculation, the more accurate your average will be. This is especially true if you have several large annual payments throughout the year.
- A rule of thumb that we use at LCW CPAs is that an emergency fund should be at least three months of spending for your business. An example is if you spend $50,000 per month on average, your emergency fund should be $150,000 at a minimum.
According to FEMA, 90 percent of small businesses that experience a disaster will fail within a year unless they can resume operations within five days. Having an emergency fund will increase the odds of your business continuing despite any hardship that may occur.
For business owners, understanding the liquidity of your business is an important metric to know and to manage. Additionally, having an emergency fund will provide you peace of mind in the event of a disaster.
If the ratios are not making sense to you, or you are wondering if your emergency fund should be larger given seasonality or significant fluctuations in your business, please contact us. We are happy to discuss the specifics of your business and help make sense of the ratios while helping you put a plan in place to strengthen the liquidity of your business as appropriate.