Liquidity

Liquidity refers to how quickly a company can turn assets into cash without drastically affecting the asset’s value. It is also known as quick ratio or current ratio. It’s an important metric for entrepreneurs and investors to evaluate when making business decisions and is often used to help assess the potential success and stability of a business.

When liquidity is high, the company can quickly and easily convert its assets into cash if needed. This gives the business the added advantage of being able to respond to sudden changes in demand or market conditions. It also provides the company with a buffer so that it can weather temporary drops in income while still being able to cover its expenses. Low liquidity, on the other hand, indicates that a company may not have the resources to address immediate needs, and it could take longer for it to secure the cash to pay for operations.

In general, businesses strive to maintain a healthy balance of liquidity, keeping enough cash on hand to cover sudden expenses or drops in income, while also avoiding keeping more than necessary and reducing returns on investment.

For example, suppose a company has $100,000 in assets. If it had a liquidity ratio of 1, this would mean that it had $100,000 in cash or investments that could be converted to cash instantly. If the ratio was 0.5, however, this would mean that only half of the assets, or $50,000, could be converted into cash, which could cause the company to struggle should it need to pay for sudden expenses.