What are liquid assets, and how to maintain a healthy liquidity ratio?
Cash is the utmost valuable item to keep a business running. Whether you are sustaining or trying to grow, your finances should be solid and secure to support your move.
But is it just your bank balance that highlights your financial state? Then what are liquid assets, and what’s their role?
Liquid assets denote every valuable possession your business owns that can be readily converted into cash. To name a few, ready cash, stocks, gold, mutual funds, and others. Liquid assets are essential to running your business without financial difficulties.
What are liquid assets?
Liquid assets are readily available cash resources or valuables that can be converted into cash anytime you need them. If we look at it this way, a car, too, is an asset. But when you sell it, you sell it at a lower price than its original value.
Hence, this cannot be a liquid asset. Assets sold without any loss on initial investment value are considered liquid assets. You can identify and tell a liquid asset from an illiquid one through the following characteristics.
• Should be able to sell the object and transfer the ownership to the buyer instantly.
• Buyers should show interest in buying/investing in your asset. It must be in demand in the market already.
Liquid assets are used in unmanageable situations where you have to break your emergency savings to save your business and sustain it.
What are some examples of liquid assets?
Cash is the finest example of liquid assets as it is constantly around and available. Accounts receivable can be also taken into account as someone is certainly liable to pay you back.
Depending on the time duration at which the assets get sold and yield you money, they are rated on the liquidity ladder. Insurance amounts that get mature sometime in the near future are also considered liquid assets.
The money you store in your savings or retirement accounts, and certificates of deposits are also an example of liquid assets. Stocks are also liquid assets as you can readily sell them at or above the market price.
Some other liquid assets that businesses typically own are treasury bonds, treasury bills, rare and precious metals, and bonds.
How is financial liquidity measured?
Financial liquidity is a way to identify if a company can use its current assets to pay off short-term liabilities. It is also necessary to determine if a business has cash resources beyond its expenditures and requirements for a sustained cash flow.
There is a liquidity asset ratio — three, in fact — that accountants commonly use.
1. Current ratio
The current ratio is an estimation of whether a company can pay off its current liabilities with its current liquid assets. Any value above one is considered a healthy liquidity ratio.
Current ratio = Total value of current assets / Current liabilities need to be paid
Here is a mock calculation of the current ratio of an imaginary company:
Total assets it owns = $5000
($1000 as inventory stocks, $2500 as accounts receivable, and $1500 as cash in a savings account)
Total liabilities = $3800
($1500 company expenses + $1000 credit repayment + $1300 vendor payments)
Current ratio = 5000/3800 = 1.3
The imaginary company has $1.3 for every $1 it owes to others.
2. Acid test ratio
The acid test is similar to the current ratio, but it only analyses the readily available liquid assets to current liabilities. If you observe the liquid assets in balance sheets, an example of readily available assets would be cash reserves.
It leaves assets that can take time to turn into cash. For instance, this ratio excludes liquid assets like stocks, inventories, mutual funds, etc.
Acid test ratio = short term cash investments / Current liabilities
3. Cash ratio
This ratio determines how you can quickly solve emergency financial problems with the immediate cash reserves you have. Here the liquid assets and current assets that are taken into consideration are only instant cash and its equivalents or anything that’s swiftly marketable.
Cash ratio = Cash equivalents /Current liabilities
Why is the liquidity asset ratio important?
A healthy liquidity ratio score marks a strong financial position. Scoring more than one in the above three ratios means that you have more immediate cash resources to tackle financial hardships.
Note that to measure the liquidity asset ratio, we only consider fixed current liabilities. Financial constraints induced due to unexpected challenges, growth plans, inflation, and natural disasters are not a part of this.
This means that just to sustain and manage the current expenses, you should have a strong cash flow. A healthy liquidity ratio is proof that you are prepared to face easier and regular cash problems. You know that your business’s financial health is solid and stable.
To grow and earn more, you tend to make investments in all forms. But if you lose focus from investing in liquid assets, you can land in trouble at any time. Cash flow problems are real. And in the end, you will be pushed to say goodbye to obligatory expenses.
Conversely, if you spend money on easily accessible assets, you can face challenging crises with ease. It’s simpler to face competition and receive bank loans. Lending institutions indirectly assess your liquid assets and current assets before helping you.
If you look into what are liquid assets, again, they are essential investments to keep your business afloat.
How to maintain a healthy liquidity ratio for your business?
1. Control overhead expenses
When business functions are going on in full swing, expenses are inevitable. However, it’s possible to control and avoid unnecessary spending. Make budgets and review past transactions to see what could have been cut down.
Remember that an increase in expenses means a steep cut on your liquidity asset ratio. You cannot have a decent, healthy liquidity ratio if your expenses are beyond your control.
Using an expense management application can accomplish this. You can track your expenses in real-time and remove or put off not-so-necessary expenses.
2. Sell unproductive assets
If you have investments that are lying down useless and not a part of the revenue, it’s time to send them off. It can be a property or a piece of machinery. Many businesses commit themselves to investing in valuables that they might use in the future.
But keeping that in reserve without making money out of it is a loss for you. Sell unproductive assets to release the money and invest in any liquid asset or keep it in your savings account. If it’s possible to rent or lease any for a short period of time, try that too.
3. Change your payment cycle
Adjusting the payment cycle of suppliers can leave you with a good cash flow. If you schedule all payments at once, your cash reserves will face a hit. Schedule your accounts payable in a way that your cash flow will not reach the bare minimum.
Have clear communication with your suppliers and ensure that their payments will be made as expected. Set budgeting targets and stick to them. Missed or delayed payments will bring in more liability as late fees. Try to avoid that by aligning accounts payable smartly.
4. Look into a line of credit
A line of credit is a short-term loan that you can borrow and pay at the month's end. Many private lenders offer credit lines to SMEs to up their cash flow capability. You can borrow and use as you go and not pay interest if repaid on time.
Struggling with never-ending debt and expenses? Try credit lines to pay off essential bills and suppliers. And plan your accounts receivable accordingly to repay the borrowed credit.
Your credit availability is determined based on your repayment history and capability. If you are lucky enough, you can manage half of your business spending with credit lines.
If the above happens, the possibility of investing in liquid assets and current assets may go up.
5. Recheck debt obligations
If you are repaying business loans monthly, pause before you take any steps. For a healthy liquidity ratio and steady cash flow, you need to strategize monthly loan dues. A long-term loan means lesser dues but longer durations.
Your monthly cash flow won’t be affected much. And you can even aim for a healthy liquidity ratio. On the other hand, short-term loans get finished quickly but you will pay more every month. Check your cash flow, liquidity of assets, debts, and monthly liabilities
6. Sweep accounts
A sweep account can get you the most of your money and be a source of liquid assets and current assets. If you have money sitting in your business account unproductively, sweep accounts are the best to receive interest on that.
You can move the excess funds from your business checking account to a sweep account at the end of the day.
If you need money suddenly, you can withdraw from sweep accounts instantly. You should also know that sweep accounts have monthly fees. And if you withdraw money before it's due, you will be charged for that.
Though a sweep account is a smart way to save your cash as a liquid asset, analyze your cash flow situation before you opt for it.
Control your overboard expenses with expense management software
We have already established how expenses are inevitable for a scaling company. Don’t you feel overwhelmed looking at charts, cost projections, and cash flow statements in the form of complex spreadsheets? It will take you forever to sort the expenses, categorize them and pick out the expensive categories.
But why juggle banking apps, spreadsheets, and invoices? Let an automated software do it all together for you. The name is Volopay which is simplifying expense management for many SMEs.
To maintain a healthy liquidity ratio, you need to concentrate extremely on budgets and money management. Why complicate it further by relying on manual, irreverent, and erroneous data?
Let me introduce you to Volopay! It has payment methods to suit all businesses. You can make local and international payments at affordable rates. You can create vendors and schedule payments ahead.
And it also has corporate cards for your recurring and one-time online payments.
Above all, it has no-collateral credit lines. You can apply within 3 minutes, get your profile assessed, and receive credits on your corporate cards. You have got an additional ten days of grace period too.
Budgets help you not spend a penny more than what’s decided for each expense type. Stay updated on where your money goes. Smartly monitor your spending and cash flow to gain strong liquid assets backup.
That depends on the type of account. A business checking account for which you pay maintenance fees cannot be called a liquid asset. Nevertheless, a savings account where you accrue interest and store cash in a readily available format, that’s a liquid asset.
Liquidity planning is the careful execution of liquid assets and current assets to avoid cash deficiency during emergencies. It can neither have too much cash in hand nor be left penniless and that takes planning. That’s exactly what liquidity management means.
To avoid a liquidity crisis, keep monitoring your liabilities, current assets, and liquid assets on balance sheets. Analyze the situation and either reduce the liabilities or spread out your financial resources. The only way to thrive and not go bankrupt is to keep the liquidity asset ratio always above one.
The fact that you can instantly turn the asset into cash without facing a loss turns an asset into a liquid.
An asset is a general term that describes any valuable possessions a business or individual owns. A liquid asset is a specific type of asset that you can easily and immediately transform into cash when you sell them.