Liquidity risk is a company’s ability to meet its short-term debt obligations. It is generally lower when you can convert assets into cash quickly and is typically higher if that is a process that will take a longer time.
Liquidity risk for business owners is an important concept to be aware of as it can impact your company’s credit and finances. Without sufficient liquidity, you may have difficulty making debt payments in a timely manner. This can result in late fees, a drop in your credit score, and the inability to restock on inventory.
If your business is experiencing liquidity or cash flow issues, you can consider getting a small business line of credit from a provider such as Bluevine. Its revolving business credit line gives you the flexibility to draw up to $250,000 on an as-needed basis, which can be well-suited to cover unexpected expenses or other circumstances that might temporarily impact your cash flow.
Business Liquidity Risk: Liquid vs Nonliquid Assets
With business liquidity risk, it’s important to distinguish liquid assets from nonliquid assets. In general, the more liquid assets your company has, the lower its liquidity risk will be. Your company’s net worth or amount of nonets
Liquid assets are those that can quickly be converted into cash that can then be used to make payments to creditors, to vendors, or for other debt obligations. The time frame for what makes an asset liquid is generally considered to be 12 months, but it can vary from one company to another. It must also be able to be liquidated quickly enough to allow the business to meet its obligations in a timely manner and at a reasonable price.
Some examples of liquid assets include the following:
- Funds in a business checking or savings account (see our picks for the best business checking accounts)
- Shares of company stock
- Funds held in a mutual fund
- Accounts receivable (A/R)
- Certificates of deposit (CDs)
- Inventory
Nonliquid Assets
An asset can be considered nonliquid if the expectation is that it would not be able to be converted to cash quickly enough to satisfy debt obligations. It can also be considered nonliquid if it would have to be sold at a price well below its market value, or if doing so would result in significant fines or penalties.
Some examples of nonliquid assets can include:
- Land and real estate
- Machinery or other business equipment
- Specialty vehicles
- Patents or other intellectual property
- Furniture and office fixtures
Example of Liquidity Risk
To illustrate the concept of liquidity risk and the role liquid and nonliquid assets can play, below is a simplified example of two businesses with varying levels of liquidity and debt obligations:
- The first company is more liquid and has a lower liquidity risk given the fact that its total liquid assets of $135,000 could cover its short-term debt payments of $35,000 several times over.
- The second company, despite the fact that it has significantly more nonliquid assets, demonstrates a high risk level as its liquid assets of $51,000 are just barely sufficient to cover its monthly debt obligations totaling $50,000.
Company 1 (Lower Liquidity Risk) | Company 2 (Higher Liquidity Risk) | |
|---|---|---|
Liquid Assets | ||
Checking/Savings Accounts | $50,000 | $20,000 |
Mutual Funds | $25,000 | $1,000 |
CD | $10,000 | $20,000 |
Value of Inventory | $50,000 | $10,000 |
Total Liquid Assets | $135,000 | $51,000 |
Nonliquid Assets | ||
Value of Real Estate | $250,000 | $1,500,000 |
Specialty Equipment | $50,000 | $500,000 |
Value of Office Fixtures | $10,000 | $100,000 |
Total Nonliquid Assets | $310,000 | $2,100,000 |
Monthly Debt Obligations | ||
Loan Payments | $5,000 | $10,000 |
Employee Salaries | $20,000 | $25,000 |
Accounts Payable (A/P) | $10,000 | $15,000 |
Total Monthly Debt Obligations | $35,000 | $50,000 |
Why Liquidity Risk Is Important
By properly managing your liquidity risk level, you’re less likely to run into cash flow issues. Otherwise, having a high level of liquidity risk makes your business credit and finances more susceptible to changes in income or expenses. Check out some of our cash flow management tips, and see the following scenarios that demonstrate how properly managing liquidity risk can benefit your business:
- You can continue building a strong business credit score: Continuing to make timely payments to your vendors and creditors is key to building a strong business credit score. And with sufficient liquidity, you decrease the likelihood of running short on funds needed for the minimum required loan payments.
- You can get approved for better rates on business loans: With a strong credit score, you also increase the chances of not only getting approved for new loans but at more competitive interest rates.
- You can save money by avoiding late fees on your debt payments: By ensuring you have enough liquidity to meet your short-term debt obligations, you can cut unnecessary expenses such as late fees or other penalties.
- You can restock inventory on credit from your suppliers more easily: With strong credit and finances, you’ll be more likely to demand competitive terms on your business agreements. This can include things like the amount and frequency of restocking on inventory and other supplies.
- You can continue to build and expand your company: Ultimately, managing your company’s liquidity risk can be crucial in building a strong, healthy business. It can help you avoid the need to sell assets at a loss and can also allow you to take advantage of limited-time opportunities that might not otherwise be possible.
How To Determine Liquidity Risk
A company’s current ratio, cash ratio, and quick ratio are three ways to calculate liquidity risk. Each factors in different aspects of your business, so you’ll want to choose the one that is best suited for your specific company. For example, the quick ratio does not consider a company’s inventory, which may indicate it’s not a good option for companies that operate in an industry where inventory can easily be converted to cash.
1. Current Ratio
The current ratio is calculated by dividing a company’s current assets by its current liabilities. It is designed to reflect a company’s ability to pay its short-term obligations that are due within 12 months. A current ratio greater than 1.00 usually means a company has the ability to meet these obligations.
Current Ratio | = | Current Assets |
Current Liabilities |
You can find information on your current assets and current liabilities by referring to your company’s balance sheet. Current assets should be indicated as items that can be converted to cash within 12 months, and current liabilities are debt obligations due within one year.
2. Cash Ratio
The cash ratio is calculated by taking the total of your company’s cash and cash equivalents, and then dividing them by current liabilities. At a minimum, you should have a ratio greater than 1.00, as it indicates your business has enough cash to cover debt payments due within a year.
Cash Ratio | = | Cash + Cash Equivalents |
Current Liabilities |
Since the cash ratio only accounts for cash and cash equivalents, it is often considered one of the more conservative methods of determining a company’s liquidity risk.
3. Quick Ratio (Acid Test Ratio)
The quick ratio is calculated by taking your company’s quick assets and dividing it by its current liabilities. It is designed to show a company’s ability to meet its short-term obligations without selling its inventory. A quick ratio of 1.00 or greater is ideal as it indicates a business can meet its short-term debt payments without needing to resort to selling nonliquid assets.
Quick Ratio | = | Quick Assets |
Current Liabilities |
As you’ll see below, calculating the quick ratio requires knowing what figure to use for quick assets. We’ve shown two separate ways that quick assets can be calculated.
Quick Assets = Cash + Cash Equivalents + Marketable Securities + Net Accounts Receivable
OR
Quick Assets = Total Current Assets – Inventory – Prepaid Expenses
How To Manage Liquidity Risk
Properly managing liquidity risk can reduce the likelihood of your business becoming insolvent. Here are some methods you can employ to ensure adequate cash flow and an improved ability to satisfy short-term debt obligations:
- Set aside funds in an emergency fund: While it may be tempting to use a large portion of your company’s revenue for growth and expansion, failing to set aside funds in a business checking or savings account to cover unexpected shortages to cash flow could be more detrimental in the long run.
- Review financial forecasts and conduct stress tests regularly: Business conditions are constantly changing, so it’s important to account for this in your financial forecasts. Consider the impact on your suppliers, potential changes in customer demand, and overall economic and market conditions for your industry.
- Diversify your investment holdings: If you have business funds held in stocks or mutual funds, diversifying these holdings can reduce the risk of experiencing a significant drop in value in a short period of time.
- Get a small business line of credit as a last resort: While it can be risky to use a credit line to meet debt obligations, it can allow you to resolve temporary cash flow issues. See our recommendations for the best small business credit lines. If you’re having difficulty getting approved, you can also check out our guide on how to get a small business loan.
Frequently Asked Questions (FAQs)
Properly managing liquidity risk reduces the chance that your company will be unable to meet its short-term obligations to vendors and creditors. Without adequate risk management, your business may become insolvent.
Liquidity risk can be determined by one of three methods. You can use the current ratio, quick ratio, or cash ratio. Each factors in slightly different aspects of your company’s assets, and you can choose the one best suited for your business.
To ensure you have sufficient liquidity to meet short-term debt obligations, you can allocate funds to an emergency fund. You can also diversify any business investments you hold, review your financial forecasts periodically to account for changing conditions in the market, or get additional funds from a business loan. To find out if you’re eligible for a loan, see our guide on small business loan requirements.
Bottom Line
Liquidity risk is a measure of your company’s ability to meet its short-term obligations and is an important concept to be aware of as a business owner if you want to reduce the likelihood of becoming insolvent. It is generally lower when you have assets that can quickly be converted into cash. To get an idea of where you stand, you can calculate your company’s quick ratio, current ratio, or cash ratio.
