Cash is King: Understanding the Power of Liquid Assets
Assets that can be swiftly converted into cash without incurring significant value loss are considered liquid. You should have a certain percentage of your wealth easily accessible in case of unexpected bills or needs. However, in a broader context, liquidity can be viewed as a spectrum: some assets can be turned into cash more quickly than others.
Here are some examples of liquid assets:
Cash is the most liquid asset since it may be quickly converted into any other form of payment if necessary. Money market accounts, savings accounts, and certificate of deposits or money that is deposited into a checking or savings account is accessible from just about any location at any time.
2. Accounts Receivable
Debts due to your company for services or products already provided are also liquid assets.
3. Certain Investments
These investments are considered liquid because they can typically be sold on short notice without a significant loss in value, and there is a big stock market of ready-to-buy investors at any moment. Stocks, bonds, mutual funds, and money market accounts are all examples of marketable assets that can be invested in.
Sometimes, online payday loans can fill this void, although they typically have very high-interest rates and should only be used as a very last choice. A business owner needs to be aware of the total value of their liquid assets.
When there is a shortage of cash, lenders are more selective about who they lend to and often demand higher interest rates for those who do. These factors may increase the likelihood of financial distress or bankruptcy for the company.
What are Liquidity Ratios?
The liquidity ratio is a crucial indicator of a company’s capacity to meet its short-term obligations without resorting to borrowing money.
Ratios like current liability to current assets evaluate how heavily your non-liquid assets weigh in comparison to your liquid assets. In the event of a financial emergency, liquidity ratios reveal how much short-term debt can be serviced.
The current ratio and the quick ratio are two of the most frequent liquidity ratios, but there are many others.
1. Current Ratio
Current ratio = current assets ÷ current liabilities
The current ratio evaluates how quickly and easily liquid assets (cash, marketable securities, etc.) can be converted into cash to settle short-term obligations (current liabilities). A higher percentage indicates more excellent financial stability. It is possible to meet present liabilities with available liquid assets if the current ratio is greater than 1.
If it’s less than 1, you may need to look into other sources of funding because your existing liquid assets aren’t adequate to cover your liabilities.
2. Quick Ratio
Quick ratio = (current assets – inventory – prepaid expenses) ÷ current liabilities.
The ability of a company to meet its short-term obligations with its most liquid assets is measured by the quick ratio, which is also known as the acid test ratio. Keep in mind that while inventories and prepaid expenses may be factored into the current ratio, they are not considered part of the quick ratio.
A quick ratio under 1 may suggest a lack of liquid assets. Since inventory and prepaid expenses cannot be quickly converted into cash to cover current liabilities, they need to be factored into a quick ratio.
Why Liquid Assets Matter for a Business
The ability to quickly access funds is called “liquidity,” and it’s essential to have it in case of any unforeseen financial emergencies. Your company’s ability to meet its debts and other commitments depends on the availability of liquid assets. Your company’s adaptability and flexibility will increase in direct proportion to the amount of liquid assets it maintains.
In the event of an emergency, you might need more time to go through the lengthy procedure of selling property or expensive machinery. Even if you do, it’s unlikely that you’ll recoup your initial investment plus its entire value in the assets.
In the event of an emergency, wherein immediate payment of a bill is required “or else,” non-liquid assets will be of little assistance. However, an emergency fund of liquid assets is helpful since it allows you to quickly and easily cover both regular and unforeseen expenses.
When asking for business loans, having a high ratio or volume of liquid assets is also helpful. Having extra money on hand can improve your credit score. You can better weather an unexpected bill or market shock if you have more cash on hand and credit available to you. Additionally, increased liquidity results in more options for running a business.
You should be able to survive financially for at least six months if you have sufficient liquid assets. Liquidity is a powerful tool that may help you construct a brighter future and keep your finances stable despite economic uncertainty. While asset liquidity can be more complicated, it is still worth exploring.
This article has been published in accordance with Socialnomics’ disclosure policy.