The Right Choice Changes Everything
Empower Your Ambition With ECS
January 18, 2023
Experts recommend having at least 3 to 6 months of operating expenses on hand. Of course, as with anything else, there is always a disparity between what’s recommended by the so-called experts, and what people actually do.
In any case, the importance of liquidity is that it can essentially make or break a business. Businesses with a high degree of liquidity have the flexibility to purchase more inventory, new equipment, or hire help.
They have an easier time expanding and growing. They can survive recessionary periods by tapping into their savings or liquidating assets. And they can also respond to emergencies with greater dexterity.
That’s the answer to the question of “why is liquidity important” in a nutshell. But how seriously do real businesses actually take this question? And what can become the end result of how they answer…or don’t answer it?
A substantial determinator of business liquidity is cash flow since the difference between inflow and outflow can result in the most liquid asset, which is actual cash. According to a study conducted by J.P. Morgan Chase, the average median daily cash outflow of a small business is $374, with an average median daily cash inflow of $381, and some wide variation across and even within industries.
For instance, restaurants had the highest inflow and outflow, at $968 and $957, respectively while personal services had the lowest at $219 and $216. While these numbers will certainly vary across industries and business sizes (you can rest assured that Coca-Cola is flowing more cash than $381) one thing becomes readily apparent: if businesses are relying on cash flow alone to build up liquidity, they are not going to get very far.
In the realm of personal services, for instance, the average median indicates that only $3 is going into the proverbial piggy bank every day. At the end of a year, this might result in around or even less than $1,000, which is not really enough to cover any kind of emergency; you couldn’t even hire a food truck for an employee appreciation day with that kind of money (for that emergency holiday season morale booster).
The same study found that the median average small business has a daily cash balance of $12,000, again with wide variation across industries. Hi-tech manufacturing was the highest at $34,200, and personal services were the lowest at $5,300. At the 75th percentile, a business had 3-4 times the average median. That means, for instance, a more liquid personal services company would have up to $21,200 on hand for emergencies or quick purchases.
But a very dismal aspect of this study found that the average median small business has only 27 cash buffer days in reserve—a far cry from the recommended optimal 3-6 months. In fact, that number indicates that the average small business is less than 16% equipped to handle an emergency, execute a quick purchase, or sail through a prolonged lull in the market.
Even more dismally, around 25% of small businesses only have 13 days cash on hand, which essentially means that any unexpected event will result in posting the proverbial “everything must go” sign on the door.
A nuanced look at this study was very revealing. Restaurants, for instance, were at the lower end of the spectrum on an industry-by-industry basis, with only 16 days in reserve. Restaurants also have very low liquidity in terms of asset class, because food and heavily used kitchen appliances are next to impossible to liquidate (and if you don’t believe it, try unloading the leftovers in your own fridge).
This might explain, for instance, the pandemic of restaurant closures that resulted from Covid-19 lockdowns and quarantines, with some estimates suggesting as many as 159,000 eateries had their chefs hang up the apron for good.
On the other hand, real estate business owners had about 47 days of operating expenses on hand. This makes sense, given the nature of real estate investing; short-term transactions like a flip must be executed quickly and may require substantial amounts of cash, while long-term investments like rentals will consistently have their fair share of surprise repairs.
And then there were businesses in the middle of the spectrum, like repair and maintenance services, which had an average of 18 days of cash reserves. Numbers like this indicate a situation where proactive, expert management can help whether the storm or lull—for instance, a flurry of market activity to drum up some more clients, or expert negotiating skills on the purchase of some replacement machinery. But inexpert or even average management can find itself in a sticky situation, all because of its mediocre liquidity.
This brings us to our next segment. What exactly is it that liquidity refers to? As mentioned, nothing is more liquid than cash. And if you can convert assets to cash, those assets are considered liquid. The easier they are to liquidate, the more liquidity they are said to have. Marketable securities like stocks, bonds, and ETFs are considered fairly liquid assets because they can be sold very quickly.
Real estate, on the other hand, is a highly illiquid asset because there are many legal formalities around its exchange that take time to process. Precious metals are also considered highly liquid, while most forms of business equipment are not, although they may be more liquid than real estate. Inventory is fairly liquid, while human capital is not…at least immediately.
In a manner of speaking, eliminating human capital can increase cash flow by decreasing your payroll costs. But then again, money that has yet to materialize from customers or clients is also not considered a liquidatable asset (although in some formulas, it is). In general, the rule of thumb to the question of whether or not an asset is liquid is if it can be sold quickly or if it’s already cash.
Aside from cash, the liquidity of your business will be determined by what type of business you run. If your business involves buying and selling gold, your business has a degree of liquidity. If your business involves preparing tax returns, it probably has a low degree of liquidity, unless the business also owns a stock portfolio with high trade volume in addition to its cash reserves.
Business liquidity can often be assessed with liquidity ratios, of which there are a few different types, discussed as follows:
This ratio measures how well a company can pay off its debt obligations within the next twelve-month period. It’s calculated very simply by dividing a ratio of current assets by current liabilities. For further clarification, the term current assets include items on the balance sheet like cash, accounts receivable, inventory, and other current assets that are expected to be liquidated in one year.
In terms of current liabilities, this includes financial obligations such as accounts payable, payroll, taxes, short-term debt, and the current year’s portion of long-term debt. For the purpose of this formula, A resulting ratio of at least 2 is desirable in most industries, while a ratio of 1 or less indicates that a business is having some solvency issues.
Money talks and Cash is King as they say. This ratio examines how well a company can immediately settle an obligation. The ratio is found by factoring in only actual cash and marketable securities (and not accounts receivable), then dividing that number by current liabilities.
As an example of a liquidity deficient business, a business with only 13 days of cash on hand (which, as mentioned earlier, is about 25% of businesses), and business loans that exceed these reserves, have a poor cash ratio.
The formula used for Operating Cash Flow Ratio is similar to the formula used for the Working Capital Ratio, but instead of examining current assets, it examines cash flow. This ratio is found by dividing cash flow by the current liabilities, to see how well a company could leverage its current cash flow to settle its existing debt obligations.
As you can see, this is not exactly a measure of a company’s static liquidity in terms of cash on hand, marketable securities, and other assets. But it does provide a good snapshot of how well they can use cash flow to sustain their liquidity.
The most commonly used ratios to assess liquidity are the Current Ratio and the Acid Test Ratio. Creditors may use these ratios to determine if a business is loan-worthy. Of course, the irony here is that a business needs money to borrow money. Or does it? Remember that inventory can be included in the Current Ratio calculation. For many businesses, this can significantly improve their liquidity ratio and their chances of getting a loan, when they need one.
But after the above discussion on the importance of liquidity, it should hopefully become apparent that waiting to get a loan until you need a loan is probably a bad idea, for several reasons.
One is that if you are needing a loan to prop up payroll and accounts payable after a lull in activity, your cash reserves may have dwindled down to the point where your acid test ratio is unattractive.
You may have slowly started liquidating your other assets and selling inventory at a discount in order to keep the business afloat, resulting in even a poor current ratio. The end result is that you’re up liquidity creek without a paddle, as you might say.
Another reason that business financing should be explored before you need funding is the interest rate. If your liquidity ratios indicate a lending risk, your interest rate will be worse than it would have been if you had sought out a loan during better times. Interest rates change, of course.
Sometimes those changes in rates coincide less than optimally for your business. Paying attention to interest rates—and seeking funding when rates are good—is the type of vigilance that can build up healthier cash reserves: a larger loan with lower payments.
Although it seems counterintuitive, getting a business loan when you don’t need one, and using that loan to create cash reserves, may be one of the smartest business moves you make. Consider our perusal of the study conducted by Chase Bank and recall how many businesses have less than one month of reserves, and how small the margin is between their inflow and outflow. Many of these businesses are putting themselves in the danger zone with their liquidity ratios—a place your business does not have to be if you explore the right business funding.
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