Introduction: Liquidity ratio is a quantitative measure of a firm’s ability to satisfy its current debt obligations as they come due, with the current assets available to it.
The two common examples of liquidity ratios used are:
- Current ratio – ratio of current assets to current liabilities
- Quick ratio or acid test ratio – ratio of current assets less inventory to current liabilities
To further understand how liquidity ratio works, we need to know what working capital is. Working capital is defined as the value of current assets exceeding the current liabilities. And the higher your working capital is, the higher is your ability to pay day-to-day expenses.
Cash is the lifeblood of a business
In order to keep the business flowing, you need to keep the cash flowing. Cash flow matters the most in a business which is why the primary objective of every entity should be liquidity instead of profitability since.
Following are a few methods of keeping your working capital healthy and hence, keeping the liquidity intact:
1. Cash Discounts
If your receivable turnover days keeps increasing, and liquidity keeps decreasing, you can use this foolproof way of recovering your debts quickly!
Introducing a 2% to 5% cash discount on clearing debts early may incentivize many of your major customers to pay their debts promptly and result in enhanced liquidity.
Even though this causes a decrease in receivables, it also results in an increase in cash with the same amount and further decrease in current liabilities of the company. Hence, the current assets (other than cash and receivables) stay almost intact whereas current liabilities reduce and thus, improve the overall liquidity ratio.
2. Inventory Management
In order to avoid major losses, take an expert’s advice, and never pile inventory! It may increase your current ratio for the time being but, at the same time, your quick ratio will keep on deteriorating. Continuous purchases will increase accounts payable (current liabilities) while there will be no cash received or receivable (current assets) resulting in a low liquidity ratio.
3. Cheaper Supplier
Overhead costs include a big chunk of payables to suppliers. In case of expensive purchases, the value of accounts payable turns out to be high as well. This results in higher current liabilities, lower working capital and lower liquidity ratio.
To improve such a situation, switching to a cheaper supplier, who may be offering discounts, will result in lower accounts payable balance and hence, a higher liquidity ratio than before.
4. Tax breaks
If applicable, you can also take advantage of tax breaks to either increase your tax credits/refunds or decrease your tax liability. A reduction in tax payable expense shall also reduce your current liability and hence, your liquidity ratio may increase.
5. Increasing profitability
The most obvious way of improving your working capital or liquidity ratio is increasing your annual net profit. An increase in net profit indicates a decrease in expenses (also a decrease in
payable expenses) and an increase in revenue (also an increase in debtors and cash).
This means that increase in profitability may reduce your current liabilities and increase your current assets resulting in a higher liquidity ratio as well as higher working capital.
Your business can achieve this by improving quality, heavy marketing, increasing efficiency, tight budgeting and so on.
6. Issuing ordinary or preference shares for cash
If you’re a company having stocks or securities listed on the stock exchange, you can issue further shares to increase the cash flow of your business.
However, his method should be used only as the last resort to boost your liquidity after trying all of the above methods or more.
A little word of advice
You should keep on visiting the current asset versus current liability section of your financial statements to avoid future consequences which may be as extreme as insolvency. Many businesses have gone bankrupt due to poor cash management. Hire a business consultant right away who can guide you the best ways of improving and maintaining your liquidity.