What is liquidity?
The term liquidity refers to the ability and willingness of a company to meet its existing payment obligations on time and in full. This definition emphasizes that liquidity is not only an essential prerequisite for maintaining normal business operations, but is also crucial for overcoming unexpected financial challenges.
Essentially, liquidity describes the availability of cash and cash equivalents that enable a company to settle invoices, salaries, rents and other short-term liabilities. A company's liquidity is often assessed using so-called liquidity ratios, including the cash ratio (liquidity 1st degree), the quick ratio (liquidity 2nd degree) and the current ratio (liquidity 3rd degree). These key figures provide an insight into the ratio of available funds to current liabilities.
The importance of liquidity for a company cannot be overemphasized, as it not only ensures solvency, but also influences creditworthiness on the market. Without sufficient liquidity, companies risk bankruptcy, which in the worst case can lead to insolvency. Comprehensive liquidity planning and taking measures to secure liquidity reserves are therefore crucial.
In business administration, liquidity is therefore regarded as one of the fundamental indicators of a company's financial health and stability. Liquidity enables a company to remain agile on the market, meet its obligations on time and thus ensure its creditworthiness and availability to raise capital. It serves not only to ensure that all obligations can be met on time, but also to maintain strategic freedom of action in order to be able to react effectively to market changes.
Liquidity basics: definition and differentiation from other financial ratios
What does liquidity mean?
Liquidity refers to a company's ability to meet all due payment obligations on time. It measures how well short-term liabilities are covered by liquid assets such as cash and bank balances and is crucial for avoiding insolvency and bankruptcy.
Difference between liquidity and profit
Liquidity and profit are fundamentally different: liquidity relates to short-term solvency, irrespective of profitability, while profit measures the long-term profitability of a company. A company can be profitable and still have short-term financial difficulties due to poor liquidity management. Liquidity ratios such as the cash ratio and quick ratio are specifically designed to analyze the short-term financial situation, as opposed to profit measures that evaluate long-term economic performance.
Measuring liquidity: understanding liquidity levels
A company's liquidity is essential for maintaining its short-term solvency and is measured by various liquidity ratios. These key figures provide information on how well a company is able to cover current liabilities.
1st degree liquidity (cash ratio)
The cash ratio, also known as first-degree liquidity, is the strictest measure of liquidity. It assesses a company's ability to settle its current liabilities exclusively with its liquid assets (such as cash and bank balances).
Formula: Cash ratio= cash and cash equivalents/current liabilities
Example: If a company has EUR 50,000 in cash and cash equivalents and EUR 100,000 in current liabilities, the cash ratio is 0.5 or 50%, which indicates that the company can cover half of its current liabilities immediately.
2nd degree liquidity (quick ratio)
The quick ratio, also known as 2nd degree liquidity, is a more comprehensive ratio that takes into account current receivables together with cash and cash equivalents to cover current liabilities.
Formula: Quick ratio = cash and cash equivalents + current receivables/current liabilities
Example: If the company also has EUR 30,000 in current receivables in addition to the EUR 50,000 in cash and cash equivalents mentioned above, the quick ratio would be 0.8 or 80%, which shows improved liquidity.
3rd degree liquidity (current ratio)
The current ratio, known as 3rd degree liquidity, is the least stringent measurement and includes all of the company's current assets to cover current liabilities.
Formula: Current Ratio= current assets/current liabilities
Example: If current assets amount to EUR 150,000, this results in a current ratio of 1.5 or 150%, which indicates that the company has sufficient funds to comfortably cover its current liabilities.
These liquidity ratios are crucial for assessing the financial health of a company and help entrepreneurs to take the necessary measures to secure their liquidity, especially in uncertain market conditions.
Liquidity planning and management are essential for survival and growth in a highly competitive market.
How companies plan and manage their liquidity
Companies plan and manage their liquidity by carefully monitoring cash flows, both incoming and outgoing. In this context, companies also consider the liquidity of 'assets' in their financial planning to ensure that they can use these assets to generate liquidity without having to sell them. This planning enables the entrepreneur to act with foresight and not just react to payment obligations. The main objectives are to minimize the risk of insolvency and to ensure that the company is always in a position to pay its bills and salaries, make investments and take advantage of growth opportunities.
Tools and methods for liquidity planning
Cash flow forecasts:
- Companies use cash flow forecasts to estimate future cash inflows and outflows. These forecasts are based on historical data, current orders and contracts as well as market trends. They enable entrepreneurs to recognize potential liquidity bottlenecks at an early stage and take appropriate measures.
Liquidity ratios:
- By regularly calculating liquidity ratios such as the cash ratio, quick ratio and current ratio, companies can assess their short and medium-term liquidity. These key figures help to monitor financial stability and are essential for liquidity management.
Working capital management:
- Efficient management of working capital, including receivables, liabilities and inventories, is crucial to optimizing liquidity. Companies can negotiate payment terms with suppliers, collect receivables faster and minimize unnecessary stock levels to improve liquidity.
Liquidity reserves:
- Building up liquidity reserves is an important strategic measure that companies take to protect themselves against unforeseen expenses and market fluctuations. These reserves can be held as cash balances or as easily liquidated assets.
Planning tools and software:
- Modern companies rely on specialized financial planning software to help them plan and monitor their liquidity effectively. These tools provide detailed insights and analyses that can be used for real-time decision-making. The anticipation and measurement of future liquidity based on the management of "economic goods" is considerably facilitated by these planning tools and software by enabling companies to efficiently assess the marketability and exchangeability of economic goods.
By combining these tools and methods, companies can effectively plan and manage their liquidity, which is essential for survival and growth in a highly competitive market.
Consequences of insufficient liquidity
A lack of liquidity can have serious consequences for a company, the most serious of which are insolvency and bankruptcy.
Insolvency
Insolvency occurs when a company is no longer able to meet its due payment obligations on time. This can happen when cash and cash equivalents and short-term liquid assets are not sufficient to cover short-term liabilities such as bills, salaries and other urgent expenses. The inability to pay suppliers or lenders on time can significantly damage the company's credit rating and impair its ability to raise capital on the market.
Insolvency
If a company's inability to pay persists and no effective measures can be taken to restore liquidity, this can lead to insolvency. Insolvency means that a company is declared legally insolvent and may be forced to cease business operations or be restructured in insolvency proceedings. This can lead to the loss of jobs, the deterioration of assets and long-term damage to the economic stability and reputation of the company.
Maintaining healthy liquidity is therefore a fundamental task of corporate management in order to ensure the financial security and continuous operation of the company.
Measures to improve liquidity
Effective liquidity management is crucial to ensuring a company's solvency and avoiding financial crises. Here are practical measures that companies can take to improve their liquidity:
1. optimization of receivables management
Companies should actively manage their receivables in order to minimize the time it takes to receive payment. This includes issuing invoices quickly and consistently following up on overdue payments. The introduction of incentives for early payments and penalties for late payments can also be helpful.
2. review of the terms of payment
Reviewing and adjusting payment terms with suppliers can improve liquidity. Extending payment terms increases the scope for disposing of cash and cash equivalents.
3. management of the stock
Reducing excess inventories through more efficient inventory management can free up cash and increase liquidity. A balanced warehouse keeps costs low and prevents capital being tied up in non-turnover assets.
4. cash management systems
The implementation of advanced cash management systems can help to use cash more efficiently. These systems facilitate the planning and forecasting of cash flows, which enables better liquidity planning and protection.
5. refinancing or new credit lines
In the event of temporary liquidity bottlenecks, negotiating new credit lines or refinancing existing liabilities under more favorable conditions can help to improve liquidity in the short term.
Frequently asked questions
What is liquidity, simply explained?
Liquidity refers to the ability of a company or person to meet all due payment obligations immediately.
What does liquidity mean?
Liquidity indicates the extent to which a company has sufficient cash and cash equivalents to cover its short-term liabilities without external financing.
What does high liquidity mean?
High liquidity means that a company or individual has extensive liquid funds that can be used immediately for payments or to cover unforeseen expenses.
What does liquidity at the bank mean?
For a bank, liquidity refers to its ability to meet customers' daily spending and withdrawal requirements, as well as the fulfillment of regulatory requirements regarding the maintenance of sufficient liquid assets.
Is liquidity money?
Yes, liquidity usually refers to money in the form of cash or other liquid assets that can be quickly converted into cash to meet obligations.
