Doesn’t sound right does it? But this scenario often happens in small businesses and the problem can sneak up on a business owner pretty easily. Everyone’s focus is on profitability, which is obviously important. After all, there is little point in being in business if you aren’t making money. But it is equally important to monitor you business’ liquidity.
Lack of liquidity can put you out of business pretty effectively if you don’t watch out for it. If you can’t meet your payroll, pay your vendors or invest in inventory needed for future sales, you’re at high risk for going out of business.
What is Liquidity?
In finance, liquidity has a variety of definitions depending upon the context. For a business, liquidity is a measure of your ability to pay your outstanding bills and other obligations.
Short term liquidity is a particularly important measurement because it highlights your business’ ability to meet its current obligations (e.g., payroll, vendor bills, payroll taxes, and interest payments.)
How Do You Measure Liquidity?
If your business’ books are up to date, you can easily determine how solid your liquidity position is by doing a little basic math…or having your bookkeeper do it for you. There are two ratios that are generally used to measure your short-term liquidity and your business’ ability to meet current bills and payroll: the Current Ratio and the Quick Ratio.
Both are calculated using the Current Assets and Current Liabilities totals on your Balance Sheet. Assuming your books are up to date, these numbers are readily available to you.
The formulas are as follows:
Current Ratio =
Current Assets ÷ Current Liabilities
Quick Ratio =
(Current Assets – Inventory) ÷ Current Liabilities
If the calculations result in positive numbers, you have a healthy result. As an example, if you have a Current Ratio of 2, it means that you have twice as many current assets as are necessary to pay your short term obligations.
However, a negative result means your obligations exceed your ability to pay them, which is a serious warning sign that you will need to address quickly.
The Quick Ratio excludes the value of your inventory, so it is a tougher standard and is often referred to as the “acid test.” Depending upon the type of business, the Current Ratio usually will suffice. But if you have slow moving inventory or high levels of inventory, you may want to use both as a reality check on how tight your liquidity position really is. You can’t pay your employees with inventory, so if a lot of your current assets are tied up in inventory the Quick Ratio may be a more realistic measure for your business.