Liquidity and Cash Flow

Liquidity describes that ability of net current assets to create cash flow. Negative liquidity will call for new cash or long term debt.

Calculating Liquidity

Also known as working capital, cash convertible current assets less current liabilities (i.e. payable within twelve months) should always be positive. Forecasting working capital is crucial to planning.

Working capital turning negative will signify a crisis. Injecting new cash by way of capital or long term loans might serve to temporarily avert that but at best it will serve to give a business time to ensure that its core trading activity can be addressed so that it is capable of generating the operating cash flow it needs to survive.

Overdrafts or other loans that can be called in at the discretion of the lender are not long term loans.

Current Assets

Cash, accounts receivable and stock / inventory are the principal liquid, current assets in that order of importance.

Other examples include prepayments (e,g. insurance) and confirmed pending refunds or discounts. Overdrawn directors' loan accounts also appear in current assets but these might be disregarded when others are calculating your liquidity.

Current Liabilities

All liabilities due for payment within twelve months are deducted from liquid assets. Long term debt (i.e. not payable within twelve months) is disregarded.

Although fixed assets play no positive part in calculating liquidity, repayments in respect of asset financing due over the next twelve months are current liabilities. This also applies to capital lease (e.g. lease purchase) agreements.

Decisions on fixed assets should always be carefully considered therefore. Even if  their cost is covered by asset finance, repayments over the coming twelve months are still charged as current liabilities.

Short Term Liquidity

Stock / inventory translates into accounts receivable in time but its cash convertibility and therefore its contribution to cash flow takes longer than from accounts receivable. Short term liquidity measures whether or not that will be too long.

If stock / inventory levels are excessive relative to their sales, some of the cash that is effectively sitting on the shelf will not be available to help pay the bills on time. Short term liquidity tests this by measuring the quick ratio or "acid test". This is calculated as - (current assets less stock / inventory) divided by current liabilities.

If quick ratio is at 1.00 or more, short term liquidity is in good shape. If it is at 0.80 or more it may be adequate but as it falls below that, restoring short term liquidity by injecting cash or loans while planning to reduce stock / inventory over the medium term will become important.

Planning Liquidity and Cash Flow

Forecasting your cash flow position for each of the coming twelve months is a vital business function. If you fail to forecast one unforeseen and therefore unaddressed cash flow deficit month, that might just create an entirely avoidable crisis.

New capital or external financing may be called for to allow time for liquid assets and / or reductions in costs to be turned into cash. If the answer is to be new external financing, you will be expected to both know and to credibly demonstrate to the potential provider of the finance how much is going to be needed; when and for how long.

That requires accurate forecasting for liquidity and cash flow. Using Figurewizard you can produce one full set of such forecasts within ten minutes or less.

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