What is the liquidity ratio?
The attractiveness of an enterprise for customers and creditors is traditionally assessed through the analysis of financial statements. Analysis of liquidity indicators is necessary both for the internal needs of enterprises and for the presentation of information in the notes to financial statements. Before we proceed to learning how to increase the liquidity ratio, let’s first find out what it means.
Liquidity can be defined as the period during which company’s assets can be converted into cash: the shorter the period of transformation of assets into cash, the higher the degree of liquidity will be, and the liquidity risk, accordingly, will be less.
In addition, it is important that the transfer of an asset into cash is not accompanied by a significant loss of its value or, simply put, the assets should be sold at market value or a price close to it. Inventories in warehouses, equipment for production, or an unfinished construction project have different liquidity.
Obviously, the most liquid assets for any organization are money, both in the form of coins and paper money and in the form of current account balances and bank deposits on demand. Equipment can be used to manufacture and market a product, while an unfinished building is of least interest. Thus, liquidity speaks of the ability of assets to be converted into cash.
Note that liquidity is a necessary and prerequisite for the company’s solvency. It is determined for the following purposes:
- Assess the solvency of the enterprise. Liquidity helps determine if it can pay off its debts.
- Find out the likelihood of getting loans. When a company has a lot of money in its accounts, as well as a significant stock of goods that can be quickly sold, this indicates a high financial reliability of the company.
- Check the interest of investors. If the only asset of the enterprise is an old factory on the outskirts of the city, and the cash register is empty, then in the event of bankruptcy creditors will wait a long time to get their money back.
Accordingly, the liquidity ratio is defined as the degree of the company’s solvency. This indicator is often used by investors and lenders to assess the financial condition when it comes to issuing loans to an enterprise or investing money in its work. The current liquidity ratio is the ratio of current assets to short-term liabilities. This is one of three important criteria that are used when assessing liquidity.
What factors affect liquidity?
The following factors affect the liquidity of an enterprise:
- the number of liquid assets
- account balances
- the volume of short-term investments
- the volume of fast-selling goods in the warehouse
- availability of authorized capital and equity capital
- the level of investment diversification
- enterprise management system
- the reputation of the company, which is determined by the media, customers, and experts.
Let’s find out how to increase the liquidity ratio for your company.
How to increase liquidity?
If you want a brief guide, there are the following ways to increase the liquidity of an enterprise:
- reduce losses and costs/expenses
- improve the liquidity of assets by increasing profits
- identify unused resources
- reduce the amount of borrowed funds
- improve working capital turnover
- reduce accounts receivable by optimizing payment policies
- analyze potential profit sources.
Now, let’s dive a little deeper. In the long term, the enterprise should implement the following measures:
- Increase profitability by increasing profits and equity capital, implementing cost control measures, and improving commercial activities;
- Attract borrowed funds on favorable terms, minimize borrowed funds;
- Increase own working capital at the expense of equity capital, retained earnings, and reserves;
- Restructure liabilities in favor of long-term borrowings;
- Implement measures to increase sales and profits.
There are also some measures a company can take to increase the liquidity and solvency of the enterprise by increasing the cash flow. Short-term measures for increasing cash inflow include optimization of the product or service range, debt restructuring, increase in sales volumes, and improvement of customer service. Long-term measures for increasing cash inflow can be summarized as the development of the financial strategy of the enterprise and the search for strategic partners.
Short-term measures for decreasing cash outflow entail reducing cost, using streamlined supply channels, and tax planning. In the long run, it is desirable to sign long-term contracts and increase equity capital to decrease cash outflow.