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How can you improve your company's liquidity?
For a company to operate smoothly, it must be solvent. This is related to liquidity, which determines whether a business can function properly. If your company has liquidity problems, read these tips to help improve its situation. Applying these practices, combined with ongoing monitoring of financial liquidity ratios, is a way to manage company finances effectively without worrying about solvency.
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Liquidity: definition
Liquidity is a company's ability to meet its current obligations on time. It also means being able to use funds to purchase products and services needed for the company's proper operation. Liquidity is one element of a company's financial assessment and directly affects its condition. A company maintaining liquidity can pay employees and creditors on time. Appropriate ratios allow any business owner to assess company liquidity independently and decide what action to take. Lack of liquidity is the first step toward business bankruptcy.
What are the liquidity ratios?
Liquidity is calculated using ratios based on current assets (working capital), meaning funds in the company account and investments that can be converted into cash relatively quickly. Three ratios are used to assess business liquidity: current, quick and cash ratios.
Current ratio:
This basic ratio gives an overall picture of the ability to meet short-term (current) obligations. Calculate it using the following formula:
current ratio = current assets / current liabilities
The higher the ratio, the smaller the share of current liabilities in current assets. Ideally it should be 1.5 to 2.0; a result below 1.0 is concerning and may indicate difficulty maintaining liquidity. Compare it with competitors' results and figures from previous periods.
Quick ratio:
This ratio measures the company's ability to cover current liabilities with more liquid assets, such as receivables and short-term investments. Inventories and goods in production are excluded from the calculation:
quick ratio = current assets - inventories / current liabilities
The ratio should be at least 1.0; a lower result indicates loss of liquidity. High values may also point to accumulated funds, suggesting the possibility of new investments. A high current ratio combined with a low quick ratio, however, indicates stockpiling and unnecessary costs.
Cash ratio:
The cash ratio assesses the ability to settle current obligations using the most liquid current assets: available cash. It shows whether the company can cover its current obligations immediately. Use this formula:
cash ratio = cash / current liabilities
The result should be between 0.1 and 0.2. An empty company account is not necessarily a cause for alarm, provided the current and quick ratios are normal and collection of receivables works efficiently.
How can you improve company liquidity?
Liquidity requires constant attention; neglect can cause serious operational problems or even bankruptcy. We have prepared eight ways to improve your company's liquidity that you can implement yourself or with our support.
1. Ensure effective debt collection processes
Late payment is a reason to begin debt collection. Of course, first try to resolve the problem amicably, especially with a regular counterparty: non-payment may result from a mistake (for example, payment to the wrong account or an invoice not received). If the customer does not respond to payment requests, refer the case to your collections department to recover the debt. If your company has no such department, you can outsource the operation to a specialist firm. Do not let it go, even for a relatively small amount. Persistently pursuing receivables shows that you are a business owner with whom disputes are not worthwhile.
2. Shorten customer payment terms
Long payment terms can harm liquidity, so one way to improve this ratio is to shorten the terms on invoices. This step may, however, damage relationships with customers, particularly if the shortening is substantial. There is a risk of losing a customer to a competitor offering more flexible
payment terms. A slight reduction in the deadline or factoring (discussed below) may solve this.
3. Extend payment terms with suppliers
An alternative to shortening customer terms is negotiating with suppliers to give your company more time to pay invoices. If you secure a longer term, you can increase the availability of funds and reduce the risks of lost liquidity or customers. Do not take this step if the supplier agrees to extend the term only in exchange for interest or additional charges.
4. Consider factoring
Factoring is invoice financing that provides earlier payment. Put simply, it turns invoices into cash: by selling a receivable to a factoring company, you can obtain funds immediately after issuing the invoice. It lets you give customers 60, 90 or even 120 days to pay while maintaining liquidity. Another benefit is not having to monitor repayment: the factoring company becomes the creditor.
There are several types of factoring, the most common being:
● disclosed factoring: the most common and cheapest kind; it requires an openly disclosed assignment of the receivable (the customer is informed and pays the factor's account); ● undisclosed factoring: a confidential assignment; the counterparty does not know about factoring, pays your account and you transfer the funds to the factor (chosen when the business worries about the counterparty's reaction); ● reverse (purchase) factoring: finances company purchases to pay an invoice sooner; ● advance factoring: provides financing even before an invoice is issued; ● non-recourse factoring: the factoring company bears the risk of the counterparty's possible insolvency; ● recourse factoring: the factoring company does not assume liability for the customer's possible insolvency.
Factoring thus provides quick payment for an invoice with minimal formalities. With non-recourse factoring, you can also transfer responsibility to the factor and avoid collection efforts if the counterparty does not pay. Does factoring have disadvantages? Certainly the service commission, although it may be deducted from the invoice amount. Disclosed factoring may signal to counterparties company liquidity problems, in which case undisclosed factoring may be preferable. Also, factoring is not
always possible: a counterparty may include a non-assignment clause in the contract, preventing transfer of the receivable to the factor.
5. Consider instalment payments
Instalment payments are one way to maintain company liquidity, allowing amounts owed to be collected in smaller portions. This provides a steady flow of cash into the business account and appeals to customers making larger purchases. It is easier to collect several smaller transfers than one large amount. Allowing instalments improves the company's appeal and competitiveness and benefits customer relationships, sales growth and range diversification. However, this option risks delayed or missing payments, requiring collection efforts. If you choose instalments, you can use external financing to transfer payment-management risk and responsibility to another entity, at additional cost, such as commissions.
6. Take out an overdraft for working capital
A working-capital loan is revolving finance in the form of an account limit, giving greater freedom to use company funds. It provides immediate access to money, funds for any purpose and liquidity protection. Another benefit is that you need not remember repayments: incoming account payments automatically repay the debt. To obtain it, however, you need creditworthiness and
security required by the bank. Financial institutions usually grant this financing to established businesses (typically operating for at least 12 months). Before taking a loan, analyse available offers for commissions and fees, preferably with a business adviser.
7. Switch to a subscription model
If the nature of your business allows, consider a subscription for your products and services. It appeals to customers while providing a steady flow of funds. Subscriptions can cover cosmetics, cleaning products, flowers, food and other items customers buy regularly. They also work for companies selling software, fitness classes, app access, meal plans or online courses. A subscription can also include free delivery, advertising packages or cleaning services.
8. Choose professional accounting
Every decision made in a business affects liquidity. Working with a professional accounting firm can help improve it. One of TaxCoach's specialities is business advice. The service includes:
● support in registering a company, ● help choosing the best form of taxation, ● support preparing and implementing business strategies and financial plans, ● help preparing and implementing procedures, ● identifying liquidity and profitability problems and recommending effective solutions, ● help creating necessary documents, ● analysis by an external chief financial officer, ● optimisation of business processes, ● advice on financing sources
Interested in this article? Explore our financial management services and see how we can help:
Summary
Our accounting firm will carefully monitor cash
flows, eliminate the risk of financial penalties (for late payments),
reduce unnecessary costs and ensure compliance, while advising
on optimising customer receivables and supplier payables.
Also important is early prevention of financial difficulties through regular
monitoring of liquidity and profitability ratios. The sooner you realise
you have a liquidity problem, the sooner you can act to
improve your company's situation.
Contact us to ask about our offer for businesses wanting to improve financial
liquidity.
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