Without the proper management of your assets and liabilities, you're at risk of ending up with financial issues that you may not be able to resolve.
The key to running a successful business is most definitely money management. It's no secret that many startups and small businesses struggle financially. As a matter of fact, 29% of all startups fail because they run out of cash at some point, while 60% of small businesses fail due to cash flow issues. That's why business owners need to focus on the liquidity of their company and how to manage it properly. Simply put, liquidity represents a company's financial performance and their ability to convert assets into cash.
Moreover, liquidity also means the extent to which an organization can meet their short-term and immediate cash obligations, without experiencing extensive losses. Therefore, liquidity management is a proper way to manage a company's assets, including cash, which will aid a company in meeting their contemporary liabilities. In other words, it stands for managing assets and cash flow, covering all the expenses and maintaining a financial stability of a business.
Now that we’ve fully explained the term, here are a few reasons why liquidity management is important for small businesses.
Assessing your financial performance
The liquidity of your small business determines how financially stable it is. Financial health is of the utmost importance to a small business, because it allows them to cover expenses, make investments and continue with their operations. Liquidity management helps small businesses assess their financial performance. Simply put, it helps you determine the amount of cash you have available to make routine payments and meet your obligations, in order to keep your business afloat.
For instance, liquidity management helps you calculate your working capital. Basically, working capital is the difference between your current assets and current liabilities that determines your company's financial health and operational efficiency. If your assets, such as cash, inventory and accounts receivable, don't exceed your liabilities (e.g. expenses and accounts payable) it means your business has liquidity issues. Your assets must exceed your liabilities in at least a 2:1 ratio in order to maintain the financial stability of your business.
Calculating the cash flow
Cash is the most important aspect of business liquidity. The main reason is that cash is the most liquid asset a business can have. In other words, it's the money you have available on-hand to cover your liabilities. Cash allows you to cover expenses and make investments instantaneously. On the other hand, other assets need to be turned into cash first, before you can use them to cover expenses. For instance, inventory has to be sold first, and payments collected before you can actually liquidize the asset. The amount of cash businesses have available determines their ability to maintain business operations.
A positive cash flow means you have enough liquid assets to cover any short-term liabilities and unexpected expenses. A negative cash flow means that you have difficulties managing your liquidity or paying off your creditors, and that your business is dangerously close to bankruptcy. Cash flow is determined by calculating the amount of cash flowing into your business from accounts receivable, and the amount flowing out of your business from accounts payable. The amount of cash you're left with is the amount of cash you have available.
Avoiding liquidity risks
Liquidity management can in many ways help small businesses avoid liquidity risks. Liquidity risks are situations when a business doesn't have sufficient funds to meet their current liability. With the right management in place, businesses can implement cash flow forecasting and liquidity buffers to avoid such risks. A good example is a business which is profitable while generating revenue, but it can still fail due to running out of money. For instance, waiting for a payment from customers via invoicing is a way for a business to completely run out of money.
Invoices take 30 to 120 days until they're due, but in the meantime, you have expenses to cover. Without cash on-hand, your business can’t operate, hence it might declare bankruptcy. However, liquidity management can prepare you for such liquidity risks in advance. You can apply for cash loans to cover your expenses while you’re waiting for the payment from the invoices. Moreover, you can sell the invoices for instant cash, while factoring companies collect payments when they're due. Either way, you're prepared to have your cash ready and meet your current liabilities.
Preparing a financial statement
Small business owners must understand their financial status in order to keep their business financially healthy. That means that you must understand how, why and where the money’s coming from and where it’s going. Liquidity management helps you prepare a financial statement that will shed light on your company's financial status. That way, you'll be able to manage your money more efficiently and make more calculated decisions when it comes to financial assessment.
You'll know how to handle your assets and liabilities properly so that your business doesn't end up in any financial trouble. What's more, you'll be able to develop the payment strategies that will help you generate more profits, improve your cash-flow and use your assets to generate the highest possible revenue. It's not the most exciting responsibility of a business owner, but it's absolutely necessary for achieving business success.
To conclude, small businesses simply need to focus on liquidity management in order to maintain financial stability and efficient business operations. Without the proper management of your assets and liabilities, you're at risk of ending up with financial issues that you may not be able to resolve.