What is liquidity and why should small businesses focus on liquidity planning?

What is liquidity and why should small businesses focus on liquidity planning?

After the past 2 years of being stuck in a pandemic many businesses have struggled and taken out loans in order to cope with their financial situation.

Between the unforeseen circumstances of covid-19 and businesses lack of preparation for such circumstances occurring, this led to many businesses not being liquid enough in order to deal with short term liabilities.

In fact, by late June 2020, more than a million UK businesses had utilised the government’s emergency financing schemes, with over £29.5 billion in the Bounce Back Loan Scheme alone.

Understanding liquidity can help businesses better to prepare for short term financial issues without having to take on more debt. This guide will provide some insight into what it means for SMEs to become more liquid and how to improve the liquidity of your business.

What is liquidity in business?

Liquidity refers to how easily a business can meet its short-term liabilities such as tax, loan payments, and bills. A business with high liquidity can easily pay off their existing financial obligations and losses without needing to take on debt.

Meanwhile, a business with low liquidity may not be able to quickly generate cash if they have no easily convertible assets and are facing unexpected extra costs.

Cash is the most liquid asset of all as it doesn’t need to be converted or sold in order to be used. Other liquid assets might be stocks, bonds and investment accounts. Conversely, assets with low liquidity include equipment, real estate, vehicles or collectibles.

Issues with liquidity can lead a business to insolvency, which means that the business cannot pay any of its debts off and is likely to shut down.

Liquidity risks and gaps

An asset with low liquidity may be seen as a liquidity risk – but don’t let the word risk scare you too much. Every company will need to have some assets with low liquidity and low liquidity doesn’t make an asset inherently bad. What it really means is that that if there’s a shortfall in income, that asset would be difficult to sell in order to make up the missing money.

For example, a gardening and landscaping company which needs a little extra money in order to pay their staff wages might need to sell some equipment off in order to get the necessary cash.

Selling front loader or tractor might make enough money to cover them for that month, however it’s not necessarily an item in high demand so it may take longer to sell than expected or may not sell at its expected market value. Having a healthy liquidity gap will ensure that you’re not taking on too many liquidity risk assets. In order to understand your businesses liquidity gap, just compare the company’s total liquid assets to its total amount of liabilities.

A big liquidity gap means that you’re at relatively low risk of insolvency while a small liquidity gap is higher risk as there’s less buffer of easily liquidated assets to handle your outstanding liabilities.

Benefits and limitations of business liquidity?

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Understanding liquidity is extremely important for small businesses as it helps them survive and grow. For example, good liquidity:

May improve your business credit score, which in turn may help you successfully secure funding from lenders.

Will help you weather emergencies or unexpected changes in business demand.

However, there can be too much of a good thing. While excessively high liquidity won’t necessary hurt your business, it may be a hindrance to growing your capital or expanding your business. Focusing too much on having high liquidity might mean missing out on essential business activities such as improving equipment, investing in new processes or premises and generally finding ways to make your cash work for you.

Ultimately, the right level of liquidity will be different from business to business depending on how big your liabilities are and how volatile your market is.

What is liquidity planning?

Liquidity planning means keeping an eye on your liquidity and ensuring that you’re financially prepared for essential expenses, unexpected events and business opportunities. The goal of liquidity planning is to make sure you don’t need to rely on loans and other debts in order to get by, while avoiding having too much cash on hand as it can often be invested or used in ways where it passively earns more money via interest.

When making liquidity plans, it can be useful to think of three types of liquidity: essential liquidity, precautionary liquidity and discretionary liquidity. Essential liquidity are your basic and immediate needs as a business such as rent or mortgages for business premises, employee wages, and business insurance.

Precautionary liquidity are your easily accessible cash reserves for emergency situations. These assets should be easy to liquidate at low cost if you should need them in a pinch. Finally, there is discretionary liquidity which will be used for opportunities you can’t pass up but which may require a larger cash investment than you’d normally have available. Part of your liquidity planning is to ensure that you have some cash in each of these categories and know how to access that cash in a quick and cost-effective manner.

Liquidity risks and gaps

The most important part of liquidity planning is knowing how to calculate your liquidity so that you can plan in the short, mid and long term. To understand your current liquidity, you’ll need to track financial in goings and outgoings such as loans, interest, business rates, tax and wages. You’ll also want to have a good idea of your market trends, customer activities and business revenue. You’ll use this information to calculate some ratios and forecast future needs.

Three different calculations often used when looking at liquidity are:

The current ratio: This is the simplest calculation and takes the broadest definition for assets.

The quick ratio: More conservative than the current ratio, this only includes assets which take less than 90 days to become cash.

The cash ratio: Again more conservative than the other two as it limits its calculation to only existing cash.

Any one of these ratios can be used – the one that’s best for you may vary depending on your business circumstances. For example, if you’re in an extremely volatile market then the most conservative calculations may help you plan more accurately. According to Investopedia, typically you’d want to keep these ratios somewhere between 1.5 and 3. Below one indicates high liquidity risk and over three may indicate that cash could be used more efficiently – but again these can vary depending on your business and industry.

How to make a liquidity plan:

There are many approaches you can take to liquidity planning, but these are some initial steps which should help you get a better understanding of how much cash you’ll need on hand in the near future and all the ways that you can generate it if you find you need more.

  1. Keep an eye on your cash
    Know where you money is expected to come in from and make sure that you’re invoicing on time – do credit checks on any companies (suppliers, distributors, etc) that you work with to ensure they’re reliable. Details all your sources of income and what you’re expecting to receive from each income stream.
  2. Assess your assets
    Take a look at every asset your business has, their value, and how liquid they are at the moment. You may need to revisit this as their value and liquidity may change over time depending on market demands. For major assets that can be used as collateral in the future you’ll want to have a clear idea of what steps would need to be taken to convert them to cash.
  3. Forecast your finances
    Start to visualise upcoming spending needs such as expansion, new premises, or equipment updates. By doing these projections, you’ll be able to start identifying excessive cash stores that you might be able to invest instead or gaps in your finances which may require liquidating some assets to cover.
  4. Categorise your needs
    As discussed above, there’s three types of liquidity needs you should think about. The essential ones, precautionary ones and discretionary ones. Start to think about how much money you need in each pot and how you’ll use your assets to get that cash should the need arise. This gives you a specific, actionable plan for accessing cash as opportunities or emergencies come up.
  5. Balance it out
    With a clear understanding of your expected income and expected needs in the immediate and long-term futures, you should start to develop an approach to asset allocation. Decide what assets you need to keep liquid and which assets you can tie up in venture that might generate additional income. All the work you’ve done prior to this should help you understand how much risk you can take on with your allocation of assets. Balancing the risk vs your expected needs is a big step in creating financial stability for your business.

If you’re feeling unsure about liquidity planning, consider consulting a financial advisor who can help you understand it better.

How to create more liquidity in business

Avoid high interest liabilities
Certain types of short-term financing can end up costing your business a lot more money in the long term as they come with extremely high interest rates. If you had to take on a short-term high-interest loan, you could look at refinancing to be a lower-interest, longer-term debt.

Look for interest bearing accounts
If you have money that isn’t immediately needed, look for bank accounts that have high interest returns to earn you some extra cash with little effort. A sweep account may help with managing this.

Improve inventory management
If you sell a product, you’ll always need to have some of your cash tied up in inventory but having a strong inventory management system can help you identify slow selling products that you don’t need as many of in your shop. This allows more money to stay as usable cash rather than having to sell the product in order to have cash again.

Reduce your outstanding debts
If you can pay off any debts such as loans or interest, it can help to improve your liquidity ratio.

Invoice efficiently
Make sure that you’re on top of issuing invoices and collecting the money that you are owed. Keeping the cash flowing in on time ensures that you have enough money to pay your own bills. Consider looking at software tools to help with this if you struggle to stay on top of it.

Sell some assets
If there are non-liquid assets which aren’t doing much for your business, consider selling them off to increase your cash reserves. This could be company cars that don’t get used much, outdated equipment or even office spaces that aren’t used anymore.

Reduce overheads
Instead of immediately renewing all of your contracts, shop around and see if you can find better rates that reduce your overall business costs. Whether this is energy tariffs, office suppliers, or other regular costs, it’s always worthwhile to see that the price you’re getting is the best one available.

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