What Small Business Owners Need To Know About Liquidity
An asset is a resource with economic value that an individual, corporation or country owns or controls with the expectation that it will provide future benefit. Current assets are assets that can easily be converted into cash. Examples are cash, inventory, debtors and etc.
Liabilities refer to those things that incur future financial obligations for the people or businesses that acquire them. Like assets, there are also current and long-term liabilities.
Current liabilities are those liabilities or financial obligations which are due within one year such as trade credit, while long term liabilities are those financial obligations that become due after one year.
Your business or company’s liquidity position refers to the ratio of its current assets to its current liabilities. This is an important metric because it lets investors know if your company is being well run and is worth investing in. It is important for your current ratio to not be too high or too low.
If your liquidity ratio is too high (greater than 2), it might raise investor’s concerns that your company is not efficiently using its current assets which implies that their investments might not yield maximum returns. At the same time, a ratio that is too low (less than 1) indicates that your company is facing an impending liquidity crisis and that you might not have enough cash to pay your bills.
It is important to know that a current ratio between one and two indicates that your company is in the right position to utilize opportunities for capital expansion, or for building inventory for increased sales.
The more short term liabilities you acquire, the greater the amount of current assets you need to acquire to maintain a good current ratio and a positive liquidity position. Because long term liabilities have no direct impact on your current liabilities, they are not included in calculations of the current ratio. This therefore means with long term liabilities you are free from the burden of having to hold as much liquid assets as possible and are able to focus instead, on other assets which might prove to be more profitable.
Conclusion
It is important to understand that your liquidity position is affected by both the amount and the type of assets and liabilities you acquire. If you are looking forward to attracting investors, or have a negative liquidity position, acquiring more long term liabilities and less short term liabilities might be the way to go.
