Although often overlooked, the liquidity ratio is of vital importance in measuring a company's ability to meet its short-term financial obligations.
In today's article, we'll explore in detail what the liquidity ratio is, how it's calculated, and why it's essential for making informed and sound financial decisions.
What is it?
The liquidity ratio is a crucial metric in the financial analysis of innovative startups and SMEs. Its relevance lies in its ability to evaluate a company's solvency and ability to pay in the short term, which is vital to ensure its survival and success in a changing and competitive economic environment.
A high liquidity ratio indicates a company's greater capacity to meet its short-term commitments, which is a positive sign for investors and managers.
Investors use the liquidity ratio as an essential tool for making informed decisions about the company's financial health. A favorable liquidity ratio suggests good working capital management and lower default risk, attracting potential investors and business partners. On the other hand, a low liquidity ratio could be indicative of financial difficulties and would require more in-depth research to identify potential problems.
In addition, the liquidity ratio is also a measure of the company's operational efficiency. A high level of liquidity may mean that the company is not using its resources optimally, as there could be excess inactive cash or uncollected receivables. On the other hand, a low liquidity ratio could be a sign of poor financial management, which could negatively affect the company's image before potential investors and creditors.
As we can see, both investors and managers can use the liquidity ratio to make informed and strategic decisions that promote the growth and sustainable success of the organization in the competitive market.
Types of liquidity ratio
There are several types of liquidity ratios that are especially relevant for innovative startups and SMEs. Among them are:
Current or general liquidity ratio:
The current liquidity ratio is one of the most common indicators for evaluating a company's ability to pay its short-term debts.
It is calculated by dividing current assets by current liabilities.
A current liquidity ratio greater than 1 indicates that the company has enough liquid assets to cover its short-term debts, which is a positive indicator for investors and suppliers.
Acid test ratio or quick ratio:
The acid test ratio is a stricter measure of a company's liquidity, since it excludes the inventory of current assets, to calculate a company's ability to meet its short-term debts with asset items.
It is calculated by dividing current assets, except inventory, by current liabilities.
If the value of the ratio is greater than 1, it indicates that the company has sufficient liquidity in its current assets to cover all its short-term obligations. As the ratio approaches 0, the company's ability to meet its short-term financial commitments decreases.
This metric is relevant for startups and SMEs that may struggle to quickly sell their inventory in case of a need for immediate liquidity.
Defensive Test Ratio:
The immediate liquidity ratio is the strictest indicator of a company's short-term solvency, showing the company's ability to pay its most urgent debts without having to sell assets or wait for collections to be made (without resorting to its sales flows).
It is calculated by dividing the value of cash and banks by current liabilities*100.
Its value, expressed in number of times, indicates the% that the most liquid part of current assets represents of current liabilities.
For innovative startups and SMEs, this ratio is fundamental, since it can reveal their capacity to face emergency situations or liquidity crises, since it eliminates the influence of the time variable and the uncertainty of the prices of other current asset accounts.
Importance of the liquidity ratio for innovative startups and SMEs
Both startups and innovative SMEs often operate in dynamic and competitive industries, where volatility is a constant. Uncertainty can affect financial stability, making the availability of cash essential to staying afloat during difficult times.
In a scenario of high volatility, these types of companies may face sudden changes in demand, unpredictable sales cycles, or cash flow delays due to business agreements or development projects. Under these circumstances, having an adequate liquidity ratio is crucial to surviving in the short term without being forced to make hasty decisions or take out expensive loans.
In addition, the innovative nature of these companies often involves significant investments in research, development and marketing, which can increase the need for capital. Having a good liquidity position allows them to take advantage of opportunities to grow and expand without relying solely on external funding. A solid liquidity ratio also provides financial flexibility, allowing them to invest in new projects or emerging technologies, which can be a key factor for their success and differentiation in the market.
Another factor to consider is that, often, innovative startups and SMEs may not have a solid credit history, making it difficult to access traditional loans. In these situations, having a strong liquidity position becomes an element of trust for investors and potential partners, which can make it easier to obtain more favorable financing or business agreements.
In addition, maintaining a good liquidity position can help these companies overcome unforeseen obstacles. Unexpected events may include regulatory changes, fluctuations in commodity prices, weather events, or other external factors affecting your operations. In such situations, having enough cash on hand provides them with a safety net to maintain their operations and face crisis situations without jeopardizing their viability.
In short, the liquidity ratio is especially relevant for innovative startups and SMEs due to the volatility and financial challenges they face on their path to growth and success. Maintaining a good liquidity position not only allows them to face contingencies and overcome obstacles, but it also provides them with the necessary financial flexibility to take advantage of strategic opportunities that will boost their development in the competitive business world.
Factors affecting the liquidity ratio
A company's liquidity ratio can be affected by a number of factors that influence the availability of cash and liquid assets. These factors may vary depending on the nature of the business and management practices. Among them are:
Sales cycle: A company's sales cycle can significantly influence its liquidity. If the period between the production and sale of products or services is long, the company may experience a lack of cash during that time, which would affect its liquidity ratio. On the other hand, if the sales cycle is short, the company can generate revenues quickly and maintain a favorable liquidity ratio.
Inventory Management: Excessive inventory can negatively affect a company's liquidity, as resources are held in the form of stored assets and are not converted to cash until they are sold. Poor inventory management can lead to additional costs and the need to resort to financing to maintain stock levels. Efficient inventory management, on the other hand, can improve turnover and contribute to a better liquidity ratio.
Collection and payment deadlines: The deadlines for charging customers and paying suppliers are crucial factors for liquidity. If the company gives generous payment terms to its customers, it may experience delays in cash inflows. Conversely, if you negotiate shorter terms with suppliers, you can improve your liquidity position by reducing cash outflows. Therefore, an adequate balance between collection and payment periods is essential to maintain a good liquidity ratio.
Operating Expenses: Controlling operating expenses is vital to maintaining a good liquidity position. An excessive increase in expenses, such as production costs or overhead expenses, can negatively impact the company's liquidity. It's essential to carefully evaluate expenses and look for ways to optimize them without compromising quality or efficiency.
Production cycle: In sectors where the production cycle is long, such as in the manufacturing industry, the company may need to finance production costs before earning sales revenue. This may temporarily affect your liquidity and require careful financial planning to ensure that payments of debts and obligations are not compromised.
Access to finance: A company's ability to access external financing can also influence its liquidity ratio. If the company has access to lines of credit or short-term loans, it can use them as an additional source of liquidity if necessary. However, over-reliance on external funding can increase short-term liabilities and negatively affect the liquidity ratio.
Benchmarking:
While it's important to keep in mind that each company and sector may have unique circumstances, having references to typical liquidity ratios in the industry provides a comparative perspective that helps identify strengths, weaknesses and opportunities for improvement. Some examples of liquidity ratios used by technological and innovative startups are:
Current or general liquidity ratio: In the startup and innovative SME industry, a current liquidity ratio considered healthy is usually between 1.5 and 2. This indicates that the company has sufficient liquid assets to cover its current liabilities. A ratio lower than 1 could indicate difficulties in dealing with short-term financial obligations.
Acid test ratio or quick ratio: The acid test ratio considered suitable for these companies generally ranges from 0.8 to 1.2. This range indicates that the company has a good capacity to face its current liabilities, excluding inventory, which is especially relevant for those with inventories that are not easy to sell quickly.
Even so, it is recommended that startups and SMEs are compared to other similar companies in their industry and region to obtain a more accurate and relevant comparison.
When benchmarking, it's essential to consider differences in the sales cycle, inventory management strategies, credit policies, and other factors specific to each company. A detailed analysis of how leading companies in the industry manage their liquidity ratios and other financial metrics can provide valuable ideas for improving financial management and strategic decision-making in innovative startups and SMEs.
Strategies to improve liquidity
To improve liquidity, innovative startups and SMEs can implement a variety of strategies to help them maintain a healthy cash flow and a strong financial position. For example:
Efficient management of working capital: Analyze and optimize inventory, accounts receivable and accounts payable levels. In addition, reducing the average collection time to customers and extending payment periods to suppliers can free up cash and improve the liquidity ratio.
Control of expenses: Evaluate and control operating expenses, identify areas where costs can be reduced without affecting the quality and efficiency of the operation, and seeking cheaper alternatives in purchases and negotiations.
Negotiating terms and conditions: Negotiate with suppliers and customers to obtain more favorable payment and collection times. This may include discounts for early payment or extension of credits.
Diversification of funding sources: Explore different financing options, such as lines of credit, short-term loans, or strategic investors. Diversifying funding sources reduces dependence on a single source and increases financial flexibility.
Cash flow management: Perform detailed monitoring of cash flows to identify patterns and potential problems. And, project future revenues and expenses to anticipate periods of low liquidity and make preventive decisions.
Credit policies: If the company offers credit to customers, establishing clear collection policies and evaluating the creditworthiness of customers before granting them credit, reduces the risk of bad receivables.
Sale of non-essential assets: Consider selling non-essential or underutilized assets to generate additional cash. This can include equipment, property, or non-strategic investments.
Financial Innovation: Explore innovative financial solutions, such as factoring, discounting promissory notes or crowdfunding, to improve liquidity in an agile way.
Profitability analysis: Evaluate the profitability of the products or services offered by the company: focusing on those that generate the highest profit margin increases cash flow.
Strategic Planning: Develop a short- and long-term financial plan that includes goals and strategies to improve liquidity. It's important to ensure that this plan is aligned with the company's growth and sustainability objectives.
The combination of these strategies with adequate planning and monitoring will allow the company to maintain its viability and growth in a dynamic and competitive business environment.
Risks associated with low liquidity
Having an insufficient liquidity ratio can entail a series of risks and significant consequences for innovative startups and SMEs. Understanding these risks is essential to take preventive measures and ensure the company's financial stability. Below, we highlight some of the main risks associated with low liquidity:
Difficulties meeting financial obligations: A low liquidity ratio means that the company may have difficulty paying its short-term debts and obligations, such as salaries, suppliers or loans. This can lead to late payments, breach of contracts and potential legal action by creditors.
Lost business opportunities: Lack of liquidity can limit a company's ability to take advantage of growth opportunities, such as strategic investments, launching new products, or expanding into new markets. The inability to capitalize on opportunities can negatively affect a company's development and competitiveness.
Deterioration of financial reputation: An insufficient liquidity ratio can cause concern among investors, customers and suppliers. This can affect the company's financial reputation and diminish the confidence of stakeholders in its ability to meet their commitments and maintain a strong operation.
Overdependence on external funding: Low liquidity can lead a company to rely heavily on short-term loans or lines of credit to meet its cash needs. This increases financial expenses and the risk of a debt spiral that makes it even more difficult to recover an adequate liquidity position.
Insolvency risk: Long-term low liquidity can increase the company's risk of insolvency, meaning that it cannot meet its financial obligations and is facing possible bankruptcy or cessation of operations.
Effect on team morale: The lack of liquidity can affect the morale and motivation of the work team, especially if the company is struggling to pay salaries or benefits on time.
Difficulties in attracting investors and business partners: An insufficient liquidity ratio can dissuade investors and potential partners, as they perceive greater financial risk when partnering with the company.
In conclusion, the risks associated with low liquidity are significant and can have a devastating impact on a company's financial health and reputation. Maintaining an adequate liquidity ratio is essential to ensure business continuity, take advantage of growth opportunities and maintain a solid financial image vis-a-vis investors, customers and suppliers. Implementing strategies to improve liquidity and maintain prudent financial management are essential to mitigate these risks and ensure the long-term success of innovative startups and SMEs.
