New Unleashed research has found firms are holding double the stock they used to due to recent supply chain disruptions. This represents a major challenge to cash flow as companies have increasingly more money tied up in inventory stock, which in turn has affected their profitability.
So maximising liquidity – whether by improving cash flow or maximising the liquidity of the stock held – has become a major focus point for many supply chain professionals.
Below, we cover how to improve liquidity and free up cash flow using nine effective strategies.
In this guide on how to improve liquidity:
What is liquidity?
Liquidity refers to the ease with which an asset or security can be converted into ready cash without affecting its current market price. In simple terms, it’s how saleable something is whilst retaining its maximum value.
Cash is deemed to be the most liquid asset due to its ready availability to cover immediate expenses such as payables, payroll, and business overheads.
There are also other types of securities which are relatively liquid. These marketable securities include common stocks and public bonds – financial assets that are easy to sell and convert into cash while also holding their value.
Liquidity vs cash flow – what’s the difference?
Liquidity is the ability of a company to meet current liabilities or immediate and short-term obligations using its current assets. While cash flow is a measure of liquidity, it simply refers to the flow of cash into and out of the business.
In short, cash flow measures the cash position of the company whereas liquidity measures all liquid assets that can be easily converted into cash.
There are many ways to improve liquidity and free up cash flow, including increasing revenue and selling redundant assets.
Liquidity and inventory: The ripple effect of inefficient stock control
Inventory has a significant effect on liquidity. The higher the level of inventory your company holds the more cash you have tied up in that stock. When inventory levels increase your company’s liquidity level will decrease.
A low inventory turnover will hurt liquidity because the cash invested in inventory stock cannot be used for other areas of the business. Prior to a sale, inventory ties up the business’s cash flow and is only converted into cash if (and when) the inventory is sold.
Liquidity and inventory are intrinsically linked. So, the higher your inventory turnover, the greater your cash flow. Better cash flow means greater liquidity.
Why inventory management is critical for improving liquidity
Effective inventory management is an important part of working capital management, and so crucial for improving liquidity.
Inventory management deals directly with the acquisition, storage, and sales of inventory, whether it is raw materials, work-in-progress or finished goods. The main goal of effective inventory management is to minimise the total amount of financial resources that are taken up by unnecessary levels of inventory stock.
Best practice inventory management improves the liquidity position of an organisation and makes available the financial resources to cover current liabilities. It also provides additional cash reserves which can then be better invested in other areas to help increase profitability.
4 ways to measure the liquidity in your business
There are three common liquidity ratios for measuring the liquidity in a business:
- current ratio
- quick ratio
- cash ratio
Additionally, the inventory turnover ratio is an equally important metric, as inventory management helps to improve the liquidity of a business. The carrying costs of inventory can have a significant impact, positively or negatively, on your cash flow and liquidity.
Let’s take a closer look at these four ways of measuring liquidity.
Current ratio
The current ratio, or working capital ratio, is the liquidity measure that determines a company’s ability to pay short-term commitments, generally those due within one financial year.
The current ratio incorporates all current assets (cash, inventory, accounts receivable, and other current assets), all current liabilities (wages, taxes, accounts payable, short-term debts), and the current proportion of long-term debt.
To calculate the current ratio, divide your total current assets by your total current liabilities.
current assets
—————————
current liabilities
The higher the current ratio the better chance your business has to pay its debts. A low ratio means you’ll have difficulties paying off immediate debts and liabilities.
In general, a current ratio lower than 2 is reasonable cause for concern.
When trying to improve liquidity in a business, you can use multiple metrics to calculate its current liquidity.
Quick ratio
The quick ratio measures a company’s short-term liquidity position to reveal its ability to meet short-term obligations using its most liquid assets.
Seen as a more conservative approach than the current ratio, the quick ratio measures the businesses capacity to pay its current liabilities without the need to sell off inventory or to secure additional financing.
The most common approach to calculate the quick ratio is to total your company’s most liquid assets and divide that amount by its current liabilities.
quick assets
—————————
current liabilities
The quick ratio is often referred to as the acid test ratio because it is used to determine how quickly a business can convert its near-cash assets for the purpose of meeting its short-term obligations.
Cash ratio
The cash ratio specifically calculates the percentage of a company’s total cash and cash equivalents compared to its current liabilities. This metric estimates the ability of a company to repay its short-term debt with cash or near-cash assets.
To calculate the cash ratio, simply combine cash and cash equivalents and divide this total by current liabilities.
(cash + cash equivalents)
——————————————
current liabilities
This metric is useful for financial lenders and creditors when deciding if, and how much, they should loan to a business.
- Learn more: 7 Cash Flow Metrics You Should Be Tracking
Inventory turnover ratio
Inventory turnover is a vital measure of business performance. The inventory turnover ratio indicates the number of times your business sells and replaces inventory stock proportional to its cost of goods sold (COGS) within a specified timeframe.
You can then divide the days within the period by the inventory turnover ratio to calculate the number of days, on average, it takes to sell your inventory and how effectively a company uses its assets.
The inventory turnover ratio helps businesses to make more informed decisions on pricing, manufacturing, marketing, and purchases.
To calculate the inventory turnover ratio, you simply divide the COGS by average inventory for the predetermined period.
cost of goods sold
—————————————
average inventory value
Average inventory is used for calculating the inventory turnover ratio to offset any seasonal fluctuations. This helps you ascertain your gross margins and is typically a more accurate measure of inventory.
The metric encompasses the purchase cost of inventory plus the cost of sales such as carrying costs, conversion costs, overheads and labour costs that are accrued within the specified period.
9 simple ways to improve liquidity in your business
Cash is the most liquid of all assets. Therefore, the best way to improve liquidity is by managing the cash in your business.
Here are nine ways that can help you to improve your liquidity.
1. Increase revenue
Increasing revenue is not always about raising prices. Putting up your prices simply as a revenue raiser can be counter-productive if your customers don’t accept the price increase. Increasing prices purely to increase cash flow can result in lost business and have the opposite effect.
Other ways for a business to increase its profitability and improve liquidity is through employing greater efficiencies. For example, optimising the production process by improving every operational stage, or by simply reducing waste.
You can also look at ways to improve products and/or services by adding more features that offer greater value to customers.
2. Control overhead expenses
Liquidity and cash flow are most negatively affected when your expenses far outweigh your income. Overhead expenses can’t be eliminated completely, but there are several ways you can reduce them.
Many business costs can be reduced by negotiating or shopping around. Look for cost-effective ways to lower fixed overheads such as rent, utilities, insurance, and transport. Try to find cheaper office and storage space or investigate renting instead of buying.
Outsource tasks that can be outsourced saving time and resources on activities that can be done cheaper and more efficiently by a third-party provider.
Bringing down overhead expenses like rent and transport can help to improve a business’s liquidity and generate more cash flow.
3. Sell redundant assets
Many business owners don’t think to convert assets into cash to improve cash flow. Eliminating surplus business equipment can provide you with a small amount of capital while also reducing your average cost of maintenance.
To decide which assets are worth selling, check the current assets that are listed on your balance sheet. Are there some items on the list that are underutilised or no longer needed?
Look to see if there are assets you could lease to free up cash flow, or refinance on better terms.
4. Change your payment cycle
Changing your payment cycle could be as simple as negotiating early payment discounts with your suppliers and offering your customers the same deal. You can save money paying suppliers early, and timely receivables from customers will also improve cash flow.
Go lean. Look for vendors who are happy to provide ‘just in time’ ordering that saves on the carrying costs of inventory.
5. Enhance accounts receivable
Ensure healthier long and short-term liquidity by improving the way receivables are managed. Invoice customers immediately after a sale is made or a service rendered. Companies that have their customer paying on invoice benefit the most.
Implement cash flow management software to track invoice due dates and automatically send payment reminders.
6. Utilise financing tactics
Financing in the case of looming cash shortages is one option to gain cash quickly. Financing is not always about taking out a loan; leasing instead of purchasing is also a good way to improve liquidity for some businesses.
Leasing can be a great alternative to making large investments in machinery or equipment which can otherwise be leased for a smaller monthly amount. That way, you can hold onto larger cash and liquid reserves without compromising your available cash flow.
7. Revisit your debt obligations
Switch out your short-term debt to long-term options to gain smaller monthly payments and give you more time to pay off the overall debt.
Consider opportunities, such as debt consolidation and loan refinancing, that also help you reduce monthly payments in the short-term and potentially save you money in the long-term.
Converting short-term debt into long-term debt can improve liquidity in a business by reducing monthly outgoing payments.
8. Automate and go digital
By automating processes, you can save time and money on manual tasks, and make better use of operational materials and other resources. Automation will also help increase efficiencies, meaning your company gains greater ongoing benefits.
Automation benefits many areas of your business from manufacturing and operational processes to administrative tasks such as marketing, HR, cash flow, and customer relationship management.
Use cash flow management software to forecast your expected income and expenses more accurately over the ensuing months. This makes it easier to manage cash because you will have a clearer picture of when cash is coming into and going out of the business. Historical data will highlight periods of peak demand or declining revenues that may affects your cash position.
9. Have a liquidity strategy in place
A liquidity strategy is a plan to improve liquidity and cash flow. Improving your liquidity comes down to planning and to understanding the difference between current, non-current and intangible assets. Liquidity is concerned only with your current assets and how they can be readily liquidated to pay down your current expenses.
If you want to improve the long-term liquidity of your business, you should develop a plan to demonstrate how you will achieve your liquidity goals and objectives. A liquidity strategy will indicate how long your money will last if revenues experience a period of continual decline.
Look to invest profits into a diverse portfolio that includes cash, bonds, and the borrowing capacity to cover the next 3–5 years of your business cash flow needs. Building a liquidity strategy will help buffer your business and help keep it operating when the unexpected occurs or in times of reduced revenues.
