If you’re a small business owner, self-employed or considering becoming one of the two, you’ve probably heard the term ‘liquidity’ bandied about. It’s a bit of a complex concept, so we’ve put together a handy guide to help you break it down.
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Understanding liquidity: definition and examples
Simply put, liquidity is how quickly you can move when it comes to payments. What this means in practice is how much cash (or other easily converted assets) you have to hand. This could be the contents of your current or savings account.
At the other end of the spectrum you have assets like your house. You wouldn’t want to sell that to pay for something else, and even if you had to, it could be a lengthy and difficult process. This makes it an ‘illiquid asset’.
An easy way to conceptualise liquidity is to think of your wealth as either water or ice. And stick with us here…
Liquid assets are water and can be easily moved, but if you’ve frozen some of your wealth - in property, shares or something similar - then it’s no longer liquid. Make sense?
Of course, should you need to, you can sell your illiquid assets, but the faster you need to do it, the worse rate you are likely to get.
Why is liquidity important for small businesses?
As we mentioned earlier, liquidity defines how quickly you can move in the financial sphere. Reduced liquidity can at best slow you down, and at worse lead to a liquidity crisis which could cause your business to fold.
Say you need to buy materials to create your products, or fit out a new business premises. To pay for that you will need liquidity - or to take out a loan. However, even if you take out a loan, you will still need to pay it back at some point, and it can be dangerous to borrow too much.
The more debt you have, the higher your liquidity risk, and the less likely you’ll be able to borrow more in future.
Of course, though materials are an illiquid asset, once you create your product you will be able to sell those for a greater price than you bought the raw materials. With items like tools and shop fittings, though they may lose value over time, having the right ones in place can increase the profitability of your business.
Liquidity management for small businesses
Liquidity is something you should consider in the initial planning stages of your business, as well as after you launch. You’ll need to evaluate how much cash is at your disposal as you plan for future projects, particularly as your business grows.
When you first start out, liquidity can be quite simple - if you have funds in your business account then you’re okay - but making sure this will still be the case in six or 12 months time is vital to the success of any small business.
Additionally, having a framework in place that allows you to plan for your business’s financial future will become invaluable as your business scales.
How to create an effective liquidity plan
In order to plan ahead, you need to know how much you’ll be spending, on what, and how often. There may be certain initial setup costs, such as creating a website or decking out a shop, that won’t need to be factored in for the future, whereas other costs will be recurring.
It’s important you keep itemised records of all your business spending, not just for tax and expenses purposes, but so that you can see exactly how much everything is costing.
If you’re not aware of what you’ve spent, then it becomes very difficult to project future spending.
On top of that, should you need to cut back on spending at any point, having a high-level overview of all your outgoing costs will make it easier to work out what can be scaled back.
Make sure you include all your expenses - from the cost of stock to how much you’re paying for electricity. Missing out certain costs will lead you to over-project your future liquidity and could leave you in financial difficulty.
There are number of tools you can use to plan your future liquidity, such as a cashflow forecast or a financial ratio analysis. You can either download a template for these - many of which can be found for free on the internet - or create your own using a spreadsheet.
How do you keep up with your business finances? Let us know in the comments.
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