Lenders and investors often use this metric to assess a company’s financial health. Here’s what owners should know (and do) about it.
A steady stream of cash is key to a successful business, but that’s just one part of the entire financial picture. It’s also important to maintain a strong liquidity ratio, which indicates the business is able to pay off its existing debts with its existing assets.
The easier an asset is to access quickly, the more liquid it is. Cash is generally the most liquid asset because it’s available at the touch of a few buttons on an ATM pad or a digital app — or sometimes in your wallet. The better a business’s liquidity ratio, the more attractive it will be to lenders and investors, both of which can be extremely important for growth.
While this may sound fairly simple, there are several ways to calculate a business’s liquidity ratios.
Understanding liquidity ratios
One of the most common types of liquidity ratios used to determine a company’s financial health is the current ratio. This compares all of the business’s current assets to all of its current obligations.
Sometimes, lenders and investors will also look at your quick ratio or your cash ratio. The former factors in only the business assets that can be accessed relatively quickly, and the latter focuses even more narrowly, comparing obligations to only cash and cash equivalents.
To calculate your business’s liquidity ratio, you’ll be dividing the assets (current, quick, or cash) by business liabilities (debts/obligations).
What the numbers mean
Lenders and investors may use liquidity ratio calculations to determine how healthy your business is. They generally want to know that you have cash flow under control, you spend responsibly, and you pay off your debts. Here’s what counts as healthy, high, or low.
- Healthy current ratio: A business with a healthy current ratio can typically meet its short-term demands and still have enough cash to invest or expand. Generally, a current ratio of 1.0 means that a company’s liabilities do not exceed its liquid assets, though this can vary by industry. Numbers below 1.0 may be acceptable in industries where there’s a quicker turnover in product and/or payment cycles are shorter. In this case, lenders may compare the business’s liquidity score to the industry average to determine its status.
- High current ratio: This refers to a ratio higher than 1.0, and it occurs when a business holds on to too much cash that could be used or invested in other ways.
- Low current ratio: A ratio lower than 1.0 can result in a business having trouble paying short-term obligations. As such, it may make the business look like a bigger risk for lenders and investors.
What business owners can do
Here are five ways to improve your liquidity ratio if it’s on the low side:
- Control overhead expenses. There are many types of overhead that you may be able to reduce — such as rent, utilities, and insurance — by negotiating or shopping around. You can also look at where you expend time and energy. One example: If your company has a paper trail, going digital can save you time and money that’s now spent 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.
- Change your payment cycle. Talk to your vendors about opportunities for discounts if you pay early, which can save you hundreds to thousands of dollars. On the flip side, you can consider offering your customers discounts for submitting payments ahead of schedule.
- Look into a line of credit. A line of credit could help you cover gaps in cash flow due to payment schedules. Some business lines of credit offer access to up to $100,000 per year, with no annual fee for the first year. If you’re considering this, compare terms before choosing a lender to work with.
- 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 it can also mean that your debt will be paid off more quickly. Also consider options like debt consolidation and loan refinancing, which may help lower monthly payments now, while also saving you money in the long-term.