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Business management should understand the various measures of the financial health of a business. Apart from cash flow management and revenue counting, there are other things that matter. One of these factors is the liquidity of a firm. It refers to the ability of a business to convert its assets into cash. As an obvious fact, companies are never out of the danger zone, and they can confront risks at any time. With that in mind, companies should always be ready for unforeseen situations. This article will explain what liquidity is and why the management should not overlook it. Keep reading to learn more!
What is Liquidity?
In layman’s terms, Liquidity refers to a firm’s ability to convert its assets into cash without affecting the underlying assets’ market price. You can’t sell a plant or machinery worth $5 million overnight, so the machine has lower liquidity. From this perspective, cash is the most liquid asset a firm can have to tackle uncertain situations. The management pays attention to the more liquid assets when dealing with such risky and uncertain situations. Following is a breakdown of assets from more liquid to least liquid. Let us walk through them quickly.
1. The most liquid assets:
Assets that are easily converted into cash in less time are said to be more liquid. These assets are categorized as follows.
i) Cash:
Cash is the more liquid asset for a business. Every firm should keep a fair bit of cash as a contingency plan to meet uncertain business needs. It is the management and the accounts team to decide how much cash to be held in hand. Need help with decisions like these? Hire the best bookkeeping and accounting firms in Dubai. These experts will keep updating you on crucial corporate matters to meet your long-term business goals.
ii) Bonds and Stocks:
Second on the list are stocks and bonds, which are considered more liquid assets after cash. The liquidity of these assets, however, depends on their trade volume. The higher the trade volume, the higher the liquidity of these stocks and bonds. Another good feature of these assets is that they are traded on their market price when liquidity is high.
iii) Investment Assets:
Another asset that falls in the category of most liquid assets is investment assets. An example of these assets is a restricted or preferred stock that is sold based on some restrictions. Even though this attribute makes them slower to convert, but they are still considered s more liquid.
2. The Least Liquid Assets:
After you have gone through the list of most liquid assets, now is the time to learn about some less liquid assets on the list. Here they are.
i) Collectable Items:
Collectable items incorporate coins, stamps, and art that are not easily sold and are considered illiquid. They are only sold out when the owner shop around enough. If you need cash urgently and intend to sell these items quickly, you need to sell them out at a discounted price. These features make these assets less liquid.
ii) Fixed Assets:
The category of fixed assets is broad. The assets which are included in this heading are plant, machinery, property, and land. Raw materials are also included in the list. All these assets are considered illiquid since you can’t sell them out overnight. They worth high, which makes them hard to sell.
Why is Liquidity Important for a Business?
The liquidity of a firm determines the financial health and ability to pay out its short-term debts. It is measured using different financial ratios like cash ratio and current ratio. The importance of liquidity for any business is discussed in the coming lines. Let us go through it quickly!
i) Need for financing:
The liquidity ratios’ role comes into play when you seek financial assistance from a third party like a bank and other financial backers. The ratios tell about your ability and strength to pay your obligations back. Moreover, it also portrays that you have enough liquidity to combat tough times.
ii) Make more informed business decisions:
Regular monitoring of your firm’s liquidity enables you to make sound decisions about your business. You can decide on business expansion or acquiring more assets when you know how much power your business has. Decisions like these are best made when you have an expert on board. Who but experienced accounting firms can help you out in this matter?
iii) Helps in tough times:
Any business can confront serious situations anytime. As an entity, you must be well prepared to tackle situations like these. liquidity of a firm is the best tool to help you tackle these situations.
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