GROUND LEVEL
Quite simply, liquidity is the ability of a company to meet its short term obligations. It’s a very ‘real world’ measure of the business’ viability and defines the company’s potential to convert its assets into cash. The phrase ‘short term obligations’, generally signifies obligations which mature within one accounting year, but it also reflects the duration of one complete operating cycle: buying, manufacturing, selling, and collecting. Any business that cannot pay its creditors on time and cannot honour its obligations to the suppliers of credit, services, and goods is technically bankrupt. The lack of liquidity leads to an inability to meet the short term liabilities, thereby affecting the company’s operations, reputation and very survival. There is also a knock-on effect too, whereby lack of liquidity leads to a worrying downward spiral. For example, lack of cash or liquid assets may force a company to miss the incentives given by the suppliers of credit, services, and goods - which of course results in higher cost of goods, compounding the raft of financial problems and eroding profitability. Liquidity is defined by your needs While it is always important for a company to maintain a certain degree of liquidity, there is no standard norm that you have to follow, or a template that sets the right standards. This depends purely on the nature of the business, the size of operations, the business’ location, and so on. The liquidity levels required by a supermarket chain like Carrefour or Sainsbury are very different from those needed by a real estate agency, for example. The importance of protecting the appropriate level of liquidity means that every stakeholder has
www.smeadvisor.com
a major interest in the liquidity position of the company. For example • Suppliers of goods will check the liquidity of the company before selling goods on credit. • Employees need to know whether the company can meet its employees’ obligations regarding salary, pension, etc. • Shareholders are interested in understanding the liquidity due to its huge impact on profitability. (Bear in mind that from an accountants’ point of view, shareholders may not like exceptionally high liquidity as profitability and liquidity are inversely related). Managing your business’ liquidity position Liquidity is best understood by comparing Current Assets against Current Liabilities. A company can protect its liquidity position by financing its investments by a combination of current and long term sources. Some of the key strategies for enhancing the liquidity position include • Financing the current assets by current sources • Financing the current assets by long term sources • Financing non-current assets by short term sources • Financing non-current assets by long term sources It is also imperative to accelerate the rate at which funds are coming into the business. For example, it will pay wherever possible to have an efficient collection system for receivables - the fundamental priority here is to shorten your receivables cycles while lengthening your own credit terms with key providers. In other words, get the money in before it goes out! Facilities such as factoring, invoice discounting and Trade Credit Insurance can all help hedge against erosion in the business’
19