Who knows what liquidity risk is? I’m sure everyone has heard the term but it’s important to understand it and manage it. Liquidity risk is the risk that a business will be unable to meet its financial commitments in a timely manner – either as short term cashflow or in the long term when loans are required.
Here are a couple of the financial ratios which can be used to identify and measure liquidity and risk.
Current Ratio is Current Assets/Current Liabilities Depending on your industry, a good ratio would be close to 2:1 and if it is lower and closer to 1:1 then maybe you should look at either increasing your current assets, reducing current liabilities or trying not to finance non-current assets with current liabilities.
Working Capital is Current Assets – Current Liabilties
It is said that a good target for working capital should be one half of operating budget. This can be improved by reducing current liabilitites such as short term debt, or increasing current assets such as the collection rate/time of accounts receivable.
Consider how you can change some fairly minor things in your business such as: –
- comparing the timing of when or how often you pay your bills with how often and how soon you are paid
- how many days your stock sits in your store or wharehouse
- how long you have to wait for a stock order to be filled once you place it (ie how long might you be without any of that stock)
Also be aware of outside influences which may have an effect on your cashflow such as seasonal fluctuations.
Are there any things that you have done in your business that you think might help other businesses manage their cashflow and their liquidity risk? We’d love to hear about them…