IN THIS LESSON
it is vital to understand...
…the liquidity of your company.
As a business owner, it is vital to understand the liquidity of your company. That is, how easily the assets that you own can be converted into cash and how much actual cash you have on hand. Discover how to determine your optimal level of liquidity by watching this video!
Video Transcript
Welcome to the importance of liquidity. By the time you're done, you'll be able to explain the concept of liquidity and why it's important for your business, calculate your liquidity ratio, identify your financial risk level, and make decisions to match your risk level to the needed liquidity for your working capital cycle. As a business owner, it's vital to understand the level of liquidity of your company, that is, how easily the assets you own can be converted into cash, how much actual cash you have on hand, and how readily you can obtain cash from a bank. A high level of liquidity comes in handy when you find yourself facing a cash shortage. For example, if you own a bakery and use $10,000 of your income to buy $10,000 worth of stock, but you don't account for the proper amount of taxes you'll need to pay later, it helps to have liquid assets, like that stock, that can be easily converted back into cash to satisfy your debts.
But it's even better to understand how to determine your optimal level of liquidity in the first place without making drastic moves. Therefore, let's learn about the concept of liquidity and how to use it to check the health of your business to make proper decisions. This video will examine how the following factors help banks determine whether your business is healthy enough to qualify for a bank loan and also alert you to your company's overall health in general. Number one, your working capital. Number two, your current ratio.
Number three, your working capital cycle. Number four, your financial risk level or debt ratio. Are you ready? Let's begin. Your liquidity ratio measures your ability to pay your suppliers, liabilities, and loans.
Two common types of your liquidity ratio are your working capital and your current ratio. Let's look at working capital first. Working capital equals your current assets minus your current liabilities. Your current assets are the assets you own that can be most easily converted into cash. As a bakery owner, this would be your cash on hand plus any raw materials or inventory that you can easily sell.
Your current liabilities are what you owe others and must pay within one year, like the ten month $30,000 loan for your new oven. You can find your current assets and liabilities on your balance sheet. If you determine your current assets are less than your current liabilities, you have a negative working capital situation. For example, let's say that you have $4,000 in cash in your bank account. In your storeroom, you have a thousand dollars worth of inventory on hand.
Your current assets, therefore, total $5,000 Imagine that you owe your suppliers $15,000 That means you have a current liability of $15,000 When you subtract your current liabilities from your current assets, you're left with negative $10,000 in working capital. That is not good. Remaining too long in a negative condition is bad for your business and you should avoid this situation. Another important measure for determining the liquidity of your business is your current ratio, which is the ratio of your current assets to your current liabilities. To calculate your current ratio, simply divide your current assets by your current liabilities.
To calculate the current ratio of the bakery from the example above, divide your current assets of $5,000 by your current liabilities of $15,000 to get a current ratio of one to three or one third as many assets as liabilities. The optimal current ratio is different for every industry. In general, you should aim for a current ratio of two to one to have twice as many assets as debt and a better ability to pay back current liabilities. Now it's your turn to calculate these all important liquidity ratios. We have learned that the working capital of your business tells you how much cash you have on hand.
The working capital cycle helps you determine how much cash you need to run your business. It's called cash to cash because you're tracking your money, beginning from the time you spend your cash for raw materials and labor required for production until you sell your finished product as inventory, and finally receive the cash from accounts receivable. The shorter you can make your cycle, the more cash you free up, so you'll need less cash on hand depending on the industry sector and payment terms. For example, if you buy $100 worth of raw materials to make 1,000 loaves of bread each day, and it takes you three days to make and sell the bread, That means you need a minimum of $300 cash to buy the raw materials before you sell the bread and get your cash back. If you sell your bread on credit to a grocery store, you will have to wait thirty days to get paid for the thousand loaves.
That means you need at least $3,100 times 30 in your business to keep buying raw materials. A cycle that is shorter than your competitors will often allow you to be more profitable, competitive, and perhaps sell goods at a lower price. To shorten your cycle, you can buy inventory or raw materials on credit, sell fewer products on credit or shorten your payment cycle, buy fewer raw materials or purchase them more frequently to reduce the amount of your cash tied up in inventory. Bankers and creditors often look at your working capital cycle to determine how long your current liabilities will remain. Determining your working capital cycle depends on the payment policy of your company.
For example, if you require your customers to only pay cash, then you'd have no accounts receivable, and your working capital cycle would be equal to your inventory cycle. Now let's take a quick review of the working capital cycle. We've learned how to measure the liquidity of your business and how to determine the optimal amount of cash you should have on hand. Let's now determine your financial risk level. Knowing the financial risk level of your business is important because it represents your company's ability to pay creditors and loans, plus make interest payments when they're due.
One important ratio in determining your level of financial risk is your debt ratio. Your debt ratio equals your total liabilities divided by your total assets. For example, if you have only 200 in liabilities and $1,000 in total assets, your debt ratio would be 20%. That would mean that only 20% of your company is financed by debt, so it would be easy to pay back loans. Banks would find this 20% debt ratio a lot more attractive than a company with a 60% debt ratio.
Average debt ratios vary by industry, but the higher your debt ratio, the more banks and creditors would view you as a risk, unable to pay your debts on time or at all. Banks prefer high profit, high liquidity companies with short working capital cycles as compared to your competitors, making for a small financial risk. Let's determine the risk situation of a sample business next.