What your liquidity ratio says about your business
When it comes to running a business, having too much cash on hand may seem like a non-issue — until it is.
Cash management terminology
Liquidity ratio: There are many facets to determining the liquidity ratio of your business. The three types include current ratio, quick ratio, and cash ratio.
Healthy current ratio: A business can typically meet its short-term demands and still have enough cash to invest or expand with a healthy current ratio. The right amount varies by industry, but a current ratio of 1.0 means that a company’s liabilities do not exceed its assets. Numbers below 1.0, though, may be acceptable in industries that have longer days payable outstanding cycles and shorter days sales outstanding cycles.
Current ratio: A type of liquidity ratio, this is a measurement of the relationship between a company’s debt and liquid assets, and a general metric of a company’s financial health. To calculate your liquidity ratio, divide current assets by current liabilities.
High current ratio: Occurs when a business holds on to too much cash that could be used or invested in other ways.
Low current ratio: Can result in a business having trouble paying short-term obligations.
Maximizing your liquidity ratio for future success and financial opportunities
As much as a steady stream of cash is key to a successful business, that’s just one part of the entire financial picture. It’s also important to maintain a strong liquidity ratio, which indicates a business is able to meet its long-term financial liabilities with its existing short-term assets.
Plus, proving a business has the ability to pay debts is key to future financial opportunities. A track record of responsible spending and timely payments shows creditors and potential investors that a business has its cash flow under control, and that the investment will be secure.
Here are four ways to improve your liquidity ratio:
Control overhead expenses. If your company has a paper trail, going digital can eliminate the costs and time of submitting and accepting paper checks.
Sell unnecessary assets. Eliminating items such as surplus business equipment can provide a small sum of capital and reduce the average cost of equipment maintenance.
Submit and ask for payments early. Leveraging invoice discounts can save your business hundreds to thousands of dollars each month. Talk to your vendors about opportunities for trade discounts, and consider offering customers discounts for submitting payments ahead of schedule. A discount calculator may help you work out whether a discount is advantageous. A line of credit could also help you cover gaps in cash flow due to payment schedules.
Revisit your debt obligations. If you have short-term debt, switching to long-term debt can require smaller monthly payments and give you more time to pay off the sum. On the flip side, switching long-term debt to short-term debt may mean higher monthly payments, but also that your debt will likely be paid off more quickly.