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Sometimes, an otherwise profitable business will run into cash-flow problems. Even with high sales, it’s possible for a company to be asset rich and cash poor. While the numbers on the books may look strong, waiting around for customers to pay can result in a cash-flow crisis.
It is a fact of life and a common struggle for small business owners: Some clients will pay late. Worse yet, others will not pay at all! Measuring the liquidity of your business will be useful for you in finding a way to weather these conditions and avoid cash shortages.
There are two measures of liquidity in commonly practice:
One measure is Working Capital. It’s the difference between the Current Assets and the Current Liabilities as seen below:
Working Capital = Current Assets – Current Liabilities
In general, assets are something that a business owns. Current Assets are items that can be cashed relatively quickly (without a fire sale) or that will turn into cash within a year or less. Examples include cash, short-term investments (such as Money Market funds, certificates of deposit, treasury bills), inventory, and accounts receivable.
On the other hand, liabilities are what a business owes. When it comes to Current Liabilities, these include accounts payable, accrued expenses, taxes payable, payments on a loan, and wages. What is current differs among companies, but accountants usually consider items of one year or less to be current.
If there’s a positive Working Capital, then the signs are that things are going okay. Usually, the bigger the surplus, the better. On the other hand, a negative Working Capital, or just a small surplus, may mean trouble is coming.
Quick Ratio is another measure of your liquidity. It indicates how capable the business is when it comes to covering Current Liabilities with Current Assets. The formula to calculate it is as follows:
Quick Ratio = (Current Assets – Inventory) / Current Liabilities
Most accountants consider a Quick Ratio of over 1 to be a measure of good liquidity. Although, it may differ among businesses, staying above 1 means you’re pretty liquid at the time of the measure.
Inventory is omitted from the Quick Ratio equation because it rarely qualifies as a liquid asset. Not to mention certain types of inventory may decay, become obsolete, or even get stolen.
These measures can change over time, so evaluate Working Capital and Quick Ratio every month or so to stay on top of your liquidity. It is equally important to measure these ratios properly. Estimates of your current assets and liabilities need to be as precise as possible.