Before we start getting into liquidity risk, repeat after me: CASH IS KING.
You will want to keep this in mind as we take a deep dive into this topic. Otherwise, you might feel like a fish out of water.
Liquidity, in essence, is your ability to meet your financial obligations with the least amount of loss. In other words, how much cold, hard cash you would be able to get for your stuff if you sold it. Imagine rummaging under your couch cushions for enough coin to buy groceries. Sure, you have some stuff you could sell, but that rare miniature gnome you just shot your wad on isn’t going to sell fast enough to stave off starvation. And you’ll probably end up losing money on the deal, to boot.
Your business liquidity risk boils down to how easily you could pay your bills in a pinch, say if all your customers were simultaneously abducted by UFOs.
- There’s not a lot of cash flow coming in
- You spend it as fast as it comes in or
- Your money is tied up in inventory or fancy office space
… you’ve got a liquidity issue, my friend.
Every single asset you have in your business falls somewhere on the liquidity scale. Obviously, cash is the most liquid and always will be. Other assets such as real estate, fine artwork, jewelry, and your collection of rare miniature gnomes are less liquid. Generally speaking, stocks and bonds are relatively liquid, depending on several factors, including the type, where it’s traded, and the current conditions of the market.
Your business liquidity is measured by how readily your business can settle both immediate and short-term liabilities. Without liquidity, your business boat will get rocked. Some of those include your monthly bills, office space, taxes, accounts payable, short-term loans, and any other payments required within a 12-month period.
On the other side of the sail, your business probably holds assets such as cash, bonds, money market funds, accounts receivable, inventory, and your 2010 regional bowling trophy. (Okay, that bowling trophy probably isn’t worth any cash, but the bragging rights are almost as valuable.)
Liquidity for a business is crucial because you never know what the future holds. (COVID-19, anyone?) Even if your business loses a significant portion of income, you’ll still have to pay the bills. That can leave you in some hot water. So, let’s dip our toes into liquidity risk.
GET SHORE ON MEASURING BUSINESS LIQUIDITY RISK
Calculating your business liquidity helps you reduce risk (more on that later). In the likelihood that you are unable to cover your bills, you’ll usually have poor cash flow. You must calculate this so that you can protect yourself if waves come crashing down on your business. Here are two of the most common methods used to measure your business’s liquidity:
Your business’s current assets divided by current liabilities. “Current” in this context means your assets can be converted into cash or paid within a 12-month period. A ratio below 1.0 can be cause for concern, but if it falls significantly, you could potentially go off the deep end.
This ratio is the same calculation as the above, however, it does not include stock. Inventory can be complicated to convert into cash without losing its value, so industries such as construction won’t include debtors in the calculation. Again, a ratio of less than 1.0 should set off a signal that your business liquidity is taking a dive.
BUSINESS LIQUIDITY RISK, SINK OR SWIM
According to Corporate Finance Institute, funding liquidity risk is when a business cannot “meet its short-term financial obligations when due.” Basically, it’s the risk that you won’t be able to settle all of your outstanding bills if things wash up. After calculating your business liquidity, you can determine where you measure up. If your business is at high liquidity risk, it’s more than likely that you have poor cash flow management. Luckily, there are ways to improve your cash flow fairly quickly, which you can read about here.
Dependency on financing makes you subject to higher funding liquidity risk, so it’s crucial that you assess your business credit score to minimize anything unnecessary. In addition, many businesses, like landscapers, face cyclical periods of cash flow, which can put them into a higher liquidity risk category. Identifying ways to decrease operational costs during those periods can alleviate that risk.
Let’s say your business makes the best vegan red velvet Bundt cakes this side of the equator. However, you’re low on cash because you took out a ton of loans for new kitchen equipment and accidentally bought 6-months’ worth of yeast. If disaster strikes, you’ll be drowning in debt. If your liquidity risk gets too high, your business will succumb to insolvency—the inability to pay any debt. It can lead to washing away all your assets, selling them at rapid-fire speed to salvage what little you can.
Liquidating your capital assets at a price lower than the market to meet your debt obligations could result in major financial repercussions—that shiny new convection oven, sold at half price. The retro-inspired mixer in a beautiful mint hue, auctioned. And in the most extreme of cases, bankruptcy. At this point, your business is a sinking ship.
SEAS THE DAY ON BUSINESS LIQUIDITY RISK
You know that saying, “Never turn your back on the sea?” That’s exactly how you should approach business liquidity risk. Now that you understand the gravity of not being able to settle all of your liabilities, here are some ways to prevent and improve your liquidity. Soak it up and get ready to make waves.
KEEP A COOL (OVER)HEAD
Get serious about cutting your costs without cutting corners. Reducing overhead is an easy way to reduce business liquidity risk. As a small business, out-of-control overhead costs can be crippling, especially in the event of difficult financial situations. It’s true that it takes money to make money, but it doesn’t mean your overhead should put you into debt.
Doing a few obvious acts like going paperless, reducing office supplies or utilities can make a big difference. Evaluate your needs around the office. If your space doesn’t make financial sense, consider downsizing or working from home. Also, reconsider subscriptions you have purchased. If you decide the subscription provides you with a high ROI, keep it, but instead of paying month-to-month, look into annual plans to save. Check merchant plans and any other fees that could be eliminated to help reduce costs. The last thing you want to do is float on overpaying on overhead.
AT YOUR OWN RISK
Are you familiar with how your business runs from beginning to end? Do you know the costs for everything utilized along the way? If not, take the time to run through your operations and crutch the numbers to learn how to improve your profit margins. This is a fantastic exercise to do with each of your employees. Not only will you be able to identify areas that you can improve upon, but you’ll also be empowering your team members to better their roles. Listen to what they have to say, they’ll know better than anyone else on how to make their job more efficient.
After you’ve worked through how your business runs, start to consider what situations could occur that would cause you to slow production or shut down. Start asking the hard questions: How much cash would it take to stay current on all your financial liabilities? How much would you need to keep operations going? How much would it take to make sure your employees are taken care of? Work the numbers, implement the necessary changes, and you’ll be ready to weather any storm.
GET YOUR MONEY ORDER
No matter where you are with your money, you must take control of your finances, or eventually, you’re going to find yourself at a high liquidity risk point. Instead of making unrealistic goals (I’m never going to sponsor another bowling league!), find a way that’s sustainable and effective for your unique business circumstances. Consider a meeting with a tax professional to make sure things are squared away before the end of the fiscal year. Taxes are complicated, and as a small business owner, there may be opportunities for you to spend money to make money. Review your financial goals and/or set new ones to improve your financial standing. Where did you spend too much money, and where could that be allocated to your business cash flow? Taking the time to get your money in order will allow you to budget more effectively and ultimately lower your business liquidity risk. You’ll be surprised at how quickly you will see waves of change.
IN YOUR DEBT
With business liquidity risk, debt can be tricky—when to use it and how do you shift your financial priorities so that you make paying it off more manageable. Unless you are already at risk, continue to focus on paying off any high-interest debt, like credit cards or loans with an interest rate that’s higher than 10%. Minimize how much you have to pay in interest to make progress on paying off debt as soon as possible. Call your creditors to see if they can lower your existing interest rate. You can also consider checking out credit card offers with 0% promotional rates for balance transfers. More than anything, debt holders want to be paid on time. Consider how borrowing money might affect you in financial emergencies. The more debt you carry, the fewer options you’ll have. The last thing you want is to be washed overboard by debt.
If things go under for your company, and you experience significant changes in your finances, managing your business liquidity risk is literally sink or swim. Which is easier to drink from when you’re dying of thirst: a block of ice or ice-cold water running from the tap? Of course, the tap. To put it into context, this is how you should think of your assets as a business owner. If they’re frozen, they will be much harder to access when it’s most needed. However, assets that are free-flowing, like the ocean, will be more beneficial if things get washed up.
If you’re ready to learn how to keep your business liquidity risk low, we’re here to throw you a line. It can be challenging to navigate the nuances of financial management on your own. We make sure that it’s all blue skies for our clients; however, if the tides turn, we’ll be here with the support and savvy you need. Reach out to us anytime, we’ll help you run a tight ship.