Why small businesses should focus on liquidity management
Minimize expenses, maximize revenue. This is the long-term goal every business in the world strives to achieve. The road to long-term solvency is a long and arduous one, laden with obstacles and seemingly insurmountable challenges, which is why startups and small business ventures have such a difficult time reaching their first year with a positive revenue stream. This is also why small businesses should weigh the pros and cons of obtaining a business loan in order to get their venture off the ground safely.
Yet, in an attempt to balance numerous proverbial balls at the same time such as marketing, revenue, customer experience, etc., entrepreneurs tend to put the fine art of liquidity management on the back burner. In reality, this is the one thing every business leader should focus on in the pursuit of long-term success. With that in mind, let’s take a look at liquidity management and why it should hold top priority in your company.
What is liquidity, you ask?
Novice entrepreneurs who don’t have a background in business management or experience in running a 21st-century company might have a tough time grasping the concept of liquidity, or why it’s so important for a small business. In essence, liquidity describes every fixed-value asset that you can sell on the open market without affecting its value. As you might have gathered by now, money is a liquid asset.
You exchange money for goods and services for a fixed price, and its value stays the same during the transaction process. Although cash is certainly not the only liquid asset on the market, it’s a prime example of liquidity due to the fact that other assets such as office furniture or other goods can be sold at various prices depending on the buyer.
Naturally, your no.1 priority as a small business owner should be to maximize cash flow (liquidity) in order to pay off your operational expenses as well as any outstanding debts in a proposed timeframe. However, things are not that simple, as liquidity will directly depend on a number of factors, such as your liabilities and cash flow ratios.
Tracking your liquidity ratios
Unlike solvency, which refers to your ability to meet your long-term financial commitments, liquidity refers to your ability to meet your short-term obligations and even sell assets quickly to raise funds. However, even if you’re doing well profit-wise, it’s still not a guarantee that you will be able to cover your operational expenses, pay off your debts, and most importantly, drive innovation.
As you can tell, constant cash flow is the name of the game in the modern business world, but you can never know when a financial drop might occur, which is why you not only want to have a contingency fund, but you also want to keep track of your liquidity ratios. These are your current ratio, your quick ratio, and your operating cash flow ratio.
Current ratio (working capital ratio) establishes your liquidity based on assets vs liabilities. If your financial advisor tells you that your current ratio is 2:1, then you have a financially healthy business. Your quick ratio is your company’s ability to cover your debts and outstanding fees. Lastly, operating cash flow ratio is exactly what it says – your ability to operate normally. You can measure your operating cash flow by adding up all of your revenue and dividing it with all of your liabilities.
Increasing liquidity safely
Unsurprisingly, your main objective should be to maximize liquidity and maintain a positive upward trajectory across the aforementioned ratios. You can do this by taking out a personal loan, minimizing liabilities, and using finance through factoring to your advantage.
Taking out a personal loan is one of the safest ways to increase cash flow for your business, and it’s arguably the quickest solution of the three. Even if your credit history is not exactly excellent, you can still find bad credit loans that will allow you to obtain cash quickly and with minimal interest rates.
The second most effective solution is to look at your “problem” from a different angle, and try to minimize your liabilities instead of increasing your liquidity. Minimizing expenses is never easy, though, and you might have to make decisions you won’t like, but which are good of the company in the long run. Still, getting rid of excess inventory is a viable tactic.
Lastly, financing through factoring allows you to “sell” your invoices to a third party that will pay what you’re owned upfront, but will take a percentage of the revenue in the process when these invoices are met by your clients. This may be a good option, although you should weigh the pros and cons before reaching a decision.
Don’t mistake profit for liquidity
Before we wrap up this somewhat lengthy guide, let’s address a common misconception that many business leaders fall prey to – profit and liquidity are not synonyms. The main difference between profit and liquidity is time. The time it takes to get paid, the time it takes for the money to actually settle down into your account, the time it takes for the bank to process the payment, these are all factors that will affect your immediate cash flow.
When you sell a product, you make a profit, but that still doesn’t mean that you have secured cash flow because money takes time to travel into your account. Sometimes, transactions could take days to process (looking at you, PayPal), which is why rather than focusing on profit, you should focus on managing your cash flow, or rather securing constant liquidity.
Modern entrepreneurs and business leaders have a lot on their plate. While there are numerous tasks that require your attention on a daily basis, liquidity management should hold top priority in your schedule. With these insights in mind, you can secure constant cash flow for your small business and pave the road to a solvent future.