Introduction
In the world of business and corporate management, liquidity is a term that is often used, but what exactly does liquidity mean? In its most basic form, liquidity refers to a company's ability to meet its payment obligations. But that's only part of the story. Liquidity has a profound impact on the stability and survival of a company. In this detailed blog post, we will look at the concept of liquidity from different angles in order to create a comprehensive understanding.
Definition of liquidity
The term liquidity comes from Latin and means "liquid". In business, however, the term has a very special meaning. Liquidity refers to the ability of a company to meet its short-term liabilities or payment obligations. It describes the availability of funds that can be used to settle these payments without becoming insolvent. Essentially, it is the liquid assets that a company has available to pay its bills and settle its debts.
Why is liquidity important?
A company's liquidity is a key indicator of its financial health. Companies with high liquidity generally have a solid financial position and a strong ability to settle their liabilities. Their solvency is strong and they have sufficient funds available to cover all costs incurred. It is also a sign that the company is well managed, as proper liquidity management is a sign of effective financial management and counteracts insolvency in advance.
The role of the entrepreneur in liquidity planning
An entrepreneur has a key role in liquidity planning. He or she must always have a precise understanding of the company's liquidity. This is the only way he or she can ensure that the company can make its payments on time and does not become insolvent. Good liquidity planning is an essential prerequisite for a company's solvency.
Liquidity ratios at a glance
A company's liquidity ratios provide a comprehensive overview of its financial health. These metrics, including liquidity ratios and other financial measures, help entrepreneurs evaluate their company's performance and make informed decisions. A good understanding of these key figures is therefore crucial for the effective management of a company.
What types of liquidity measures are there?
There are various measures of liquidity to differentiate between the different options for generating liquidity. A distinction is made between the following degrees of liquidity:
1st degree of liquidity
2. degree of liquidity
3. degree of liquidity
A specific formula can be used to determine an economic liquidity ratio, which provides a company's controlling department with information about the company's solvency. This key figure can be used to estimate whether payment difficulties could arise in the future.
In the first degree of liquidity (liquidity 1), also known as the cash ratio or cash liquidity, cash and cash equivalents are compared with current liabilities. These usually include loan repayments and trade payables. Cash on hand, checks or bank balances, for example, are used to calculate cash liquidity.
Calculation of the 1st degree of liquidity Receivables are not included in this calculation. First-degree liquidity therefore illustrates the extent to which the company is in a position to meet its short-term payment obligations using only its liquid assets. The guideline value for the first degree of liquidity is around 20%.
2nd degree of liquidity: The second degree of liquidity (liquidity 2), also known as the quick ratio, represents the relationship between the following factors:
Financial assets (all factors of the first degree of liquidity), current assets securities and current receivables in relation to a company's current liabilities, which can be used to calculate whether a company is in a position to settle all of its current liabilities.
Calculation of the 2nd degree of liquidity With the second degree of liquidity, the guideline value is 100%, as the financial assets are then sufficient to cover all current liabilities and there are also reserves available. If the value is below 100%, the company has too few assets available in the short term to cover all debts. This can lead to liquidity shortages.
3rd degree of liquidity: The third liquidity level (liquidity 3), also known as the current ratio, represents the total current assets in relation to the current liabilities. Current assets include financial assets, securities, receivables and other assets and inventories. In this way, it is possible to calculate how liquid the company is in the long term.
Calculation of the 3rd degree of liquidity The third degree of liquidity should ideally be around 200% in order to be able to cover even more than the current liabilities with current assets and not have to fall back on fixed assets. With a guideline value of 200%, financial bottlenecks can be avoided even if a customer does not pay an invoice.
The consequences of a lack of liquidity
A liquidity shortage, i.e. when a company does not have enough liquidity, can result in it not being able to meet its payment obligations. This can manifest itself in payment difficulties which, if not resolved, can lead to serious problems, including insolvency. If a company is unable to service its debts, it can lose its customers and suppliers and fall into a financial crisis.
Solvency vs. liquidity
Although the terms solvency and liquidity are often used interchangeably, there is a subtle but important difference. While solvency refers to the general ability of a company to meet its long-term obligations, liquidity refers specifically to the ability to meet these obligations in the short term.
Liquidity vs. profitability
There is often a trade-off between liquidity and profitability. Companies that aim for high liquidity may miss opportunities for profitable investments, as they tend to hold money in the form of cash rather than investing it.
Assessment of liquidity
Assessing a company's liquidity is not a simple process. It requires a thorough analysis of the company's financial situation, including consideration of liquidity ratios and cash flows. In addition, the specific industry in which the company operates and the general market conditions must be taken into account.
Importance of liquidity reserves
Liquidity reserves are a buffer that companies use to cover unexpected costs or losses. They are an important part of liquidity planning, as they ensure that the company remains solvent even in times of crisis. Companies that have sufficient liquidity reserves are generally more resistant to financial shocks and can maintain their business activities even in difficult economic times.
What are the consequences of excessive liquidity?
Although an excess of liquidity is not as worrying as a lack of liquidity, it can still cause a loss of profitability. This means that if a company hoards an excessive amount of cash and invests only minimally, it can easily meet its payment obligations, but forgoes potential interest income and exposes its assets to the risk of depreciation due to inflation. To avoid such situations, surplus liquidity can be invested in the form of fixed-term deposits, corporate fixed-term deposits or overnight money, for example, to generate interest income and counteract inflation.
How can liquidity be improved?
There are various approaches for companies to improve their liquidity. This includes increasing income, reducing expenses, improving receivables management and optimizing working capital management. Another option for the company is to use short-term receivables to create additional liquidity, for example by collecting outstanding customer invoices more quickly.
What are liquid investments?
Liquid investments are forms of investment that can be converted into cash quickly and without significant loss of value. Such investments include overnight or fixed-term deposit accounts, money market funds, short-term bonds or shares in large companies traded on stock exchanges. These investments make it possible to react quickly to financial needs and at the same time achieve a certain return. Their main characteristics are availability and security: they are usually easily accessible and their value generally remains stable. This makes them an important part of a company's liquidity strategy, as they increase both the security and flexibility required for successful liquidity management.
Conclusion
Liquidity is a key component in corporate management and financial planning. It not only influences the short-term performance of companies, but also plays a decisive role in their long-term stability and growth. A sound understanding of liquidity and its importance is therefore essential for every entrepreneur.
Efficient liquidity management enables a company to meet its financial obligations and at the same time have sufficient financial resources to invest in future growth. It enables a healthy cash flow to be maintained and helps to reduce financial risks.
However, achieving the right balance between liquidity and investments is not always easy. Too much liquidity can lead to financial resources not being used optimally, while too little liquidity can jeopardize the survival of the company. It is therefore of the utmost importance to find a balanced approach and to regularly review and adjust the liquidity situation.
The ability to manage liquidity effectively can indeed decide the fate of a company. In times of financial uncertainty, it can ensure the company's ability to survive. In times of growth, it can provide the necessary flexibility to take advantage of new opportunities. Liquidity management should therefore always be a central aspect of corporate strategy and a top priority for management. Because without sufficient liquidity, no company will be able to achieve its goals and realize its vision.
