Liquidity refers to the ability of a company or an individual to settle short-term liabilities easily and on time. It reflects how quickly and efficiently assets can be converted into cash without losing significant value.
In a business context, liquidity refers to the availability of means of payment, such as cash and bank balances, and the ability to mobilize these funds in a timely manner. A high level of liquidity means that a company is able to meet its ongoing obligations, such as paying salaries, servicing suppliers and covering unexpected expenses, without having to resort to external sources of funding.
In the financial world, liquidity is also a measure of the ease with which securities or other assets can be bought or sold on the market. A liquid market is characterized by high trading activity and low price volatility, which allows participants to execute transactions quickly and without high costs.
There are various forms of liquidity:
Liquidity is a key indicator of financial health and stability and plays an important role in decision-making in the financial and corporate world.
In summary, liquidity is a key element in the financial stability and flexibility of both companies and individuals. It significantly influences the ability to overcome financial challenges and take advantage of economic opportunities.
Liquidity is crucial in the financial world and for companies and individuals for several important reasons:
Overall, liquidity is a key aspect of financial health and sustainability. It ensures the fulfillment of ongoing obligations, strengthens the confidence of investors and lenders, offers flexibility in times of crisis and contributes to the long-term stability and growth of a company.
Balanced liquidity management is critical to ensure both financial stability and efficient capital utilization. Here is a table that summarizes the effects of too little and too much liquidity in a company:
| Criterion | Liquidity too low | Liquidity too high |
|---|---|---|
| Solvency | Difficulty paying short-term liabilities | No direct solvency problems |
| Creditworthiness | Deteriorating creditworthiness, difficult access to credit | High creditworthiness, easy access to credit |
| Operational stability | Risk of payment defaults and supply bottlenecks | Stable, but inefficient use of capital |
| Financial flexibility | Limited flexibility in the event of unexpected expenses or investments | High flexibility, but possible loss of return opportunities |
| Costs | Increased financing costs due to short-term loans | Opportunity costs due to uninvested capital |
| Investments and growth | Limited ability to invest in growth projects | Potentially lower returns due to conservative approach |
| Risk management | Higher insolvency risk | Low insolvency risk, but possibly too conservative risk policy |
| Profitability | Potential loss of profitability due to increased financing costs | Lower profitability due to capital not being optimally utilized |
| Supplier and customer relationships | Deterioration of relationships due to late payments | Stable relationships, but may be perceived as too conservative |
Too little liquidity: A company with too little liquidity has difficulty paying its short-term liabilities, which leads to increased financing costs, a deterioration in creditworthiness and limited financial flexibility. This increases the risk of payment defaults, restricts investment opportunities, and can have a negative impact on profitability and operational stability.
Too much liquidity: A company with too much liquidity may not have direct solvency problems and enjoy a high credit rating and financial flexibility, but it may not use its capital efficiently. This leads to opportunity costs and lower returns as capital is not invested in growth-enhancing projects or assets.
Liquidity planning is an essential part of a company's Financial Management. It ensures that sufficient liquid funds are available at all times to settle liabilities and react flexibly to financial challenges. This promotes stability, efficiency and confidence in the financial health of the company. The following reasons explain why liquidity planning is important and how it helps to ensure liquidity.
Careful liquidity planning ensures that a company is able to settle its short-term liabilities at all times. This prevents payment defaults, which can lead to a loss of confidence among suppliers and customers as well as legal consequences.
By forecasting and monitoring future cash inflows and outflows, a company can identify potential financial bottlenecks at an early stage and take appropriate measures to avoid them. This can include taking out short-term loans or reallocating assets.
Effective liquidity planning helps to optimize cash flow by ensuring that sufficient funds are available for operating expenses, investments and unexpected expenses. This contributes to the stability and efficiency of business operations.
Liquidity planning provides valuable insight into a company's financial position and supports management in making strategic decisions. This includes investments, expansion, acquisitions and the introduction of new products or services.
Well-planned liquidity management shows lenders and investors that the company has its finances under control, which can lead to better credit terms and easier access to financing.
By planning and building up liquidity reserves, a company is better prepared for unexpected events such as market changes, economic crises or sudden drops in revenue. This increases the company's resilience and long-term survival.
By continuously monitoring and adjusting liquidity, a company can ensure that surplus funds are used efficiently, whether by investing in profitable projects or reducing debt.
Good liquidity planning can prevent the need for expensive emergency financing, which is often associated with high interest rates and unfavorable terms. This saves costs and protects the financial health of the company.
Important terms relating to
liquidity explained!
| Liquidity | The ability of a company to settle short-term liabilities on time. |
|---|---|
| Cash and cash equivalents | Cash and bank balances that are immediately available to settle liabilities. |
| Liquidity ratio 1st degree | Ratio of cash and cash equivalents to current liabilities; shows the ability to make immediate payments. |
| 2nd degree liquidity ratio | Ratio of cash and cash equivalents and current receivables to current liabilities; measures the ability to pay quickly without selling inventories. |
| 3rd degree liquidity ratio | Ratio of total current assets to current liabilities; indicates the extent to which the company can cover its current liabilities. |
| Cash flow | The net inflow of cash and cash equivalents from a company's operating, investing and financial activities. |
| Cash flow ratio | Ratio of operating cash flow to current liabilities; shows the ability to cover liabilities with operating cash flow. |
| Working capital | Difference between current assets and current liabilities; an indicator of short-term financial health. |
| Liquidity planning | Process of forecasting and monitoring future cash inflows and outflows to ensure sufficient liquidity. |
| Liquidity management | Measures to manage and optimize liquidity, including the use of credit lines and management of receivables and payables. |
| Market liquidity | The ease with which assets can be bought or sold on the market without causing significant price changes. |
| Corporate liquidity | The ability of a company to meet its short-term financial obligations. |
| Bank liquidity | Availability of liquid funds at banks to meet their daily financial requirements. |
| Receivables | Outstanding invoices to be settled by customers in a short period of time. |
| Liabilities | Financial obligations of a company that must be settled within a certain period of time. |
| Operating cash flow | The cash flow from a company's main business activities; shows the financial performance of the core business. |
| Opportunity cost | Potential income foregone by choosing a particular investment opportunity over an alternative. |
| Financing costs | Costs incurred through borrowing, including interest and fees. |
| Creditworthiness | Assessment of a company's ability to meet its financial obligations; influences the terms on which loans can be taken out. |
This table provides an overview of the most important terms relating to liquidity and their significance for the financial management of a company.
Liquid assets include all assets that can be converted into cash quickly and without major losses in value. These assets are crucial for the short-term solvency of a company or individual.
In general, liquid assets comprise the following items, which are shown in this overview:
These items are often included in the various liquidity ratios to assess a company's ability to settle short-term liabilities. Liquid assets are essential for maintaining solvency and the ability to react to financial bottlenecks or unexpected expenses.
The difference between liquidity, profit and cash flow can be explained as follows:
| Aspect | Liquidity | Profit | Cash flow |
|---|---|---|---|
| Definition | Ability to settle current liabilities | Excess of income over expenses | Net cash inflow |
| Focus | Short-term financial stability | Long-term earning power and profitability | Actual liquidity movement and financial flexibility |
| Key figures | Liquidity ratios, cash ratio | Gross profit, EBIT, net profit | Cash flow statement, free cash flow |
| Time horizon | Short-term | Long-term | Short- and long-term |
| Relevance for | solvency, survival in times of crisis | economic success, profitability | financial planning, investments, liquidity management |
| Influence of | Availability of cash and cash equivalents | Income, expenditure, accounting methods | Operational, investment and financial activities |
| Example | Cash on hand, bank balances, current receivables | Sales minus costs (incl. non-cash items) | Income from sales minus operating costs |
Liquidity is decisive for short-term solvency.
Profit shows the economic success and profitability over a period.
Cash flow provides an insight into the actual cash flows and the financial flexibility of a company.
A company's liquidity can be assessed using various ratios that provide information on the ability to settle short-term liabilities. The most important liquidity ratios include the following.
In order to calculate the liquidity of a company using a concrete example, we look at the balance sheet of a fictitious company. Let's assume that the balance sheet has the following values:
These key figures provide a comprehensive overview of a company's liquidity and help to assess short-term financial health and the ability to service liabilities on time.
What do static &
dynamic liquidity mean?
| Aspect | Static liquidity | Dynamic liquidity |
|---|---|---|
| Definition | Valuation of liquidity at a specific point in time | Valuation of liquidity over a specific period of time |
| Basis | Balance sheet values | Future cash inflows and outflows |
| Key figures | Liquidity ratio 1st degree (cash ratio) | Cash flow analysis |
| 2nd degree liquidity ratio (quick ratio) | Liquidity planning | |
| 3rd degree liquidity ratio (current ratio) | Liquidity management | |
| Focus | Snapshot of the financial situation | Long-term maintenance of liquidity |
| Goal | Recognizing current liquidity bottlenecks | Ensuring sufficient liquidity in the future |
| Benefit | Quick assessment of current financial health | Long-term financial planning and management |
| Helps with short-term decisions | Takes into account seasonal fluctuations and future obligations | |
| Useful for credit scoring | Understanding long-term stability and resilience to shocks | |
| Limitations | No consideration of future cash flows | Complexity of forecasting future cash inflows and outflows |
| Snapshot that can change quickly | Requires comprehensive and continuous monitoring |
Both approaches, static and dynamic liquidity, provide a comprehensive picture of a company's liquidity situation. While static liquidity provides a snapshot, dynamic liquidity enables forward-looking and sustainable financial planning. This table provides a clear comparison of static and dynamic liquidity and illustrates their respective importance for a company's financial planning.
Various measures can be taken to improve a company's liquidity. Here are some proven strategies that can help increase financial flexibility and stability:
These measures can help to improve a company's liquidity by optimizing cash flow, reducing costs and increasing financial flexibility. Regular monitoring of liquidity and adapting strategies to current business conditions are essential.
A liquidity trap occurs when monetary policy loses its effectiveness because interest rates are already so low that additional money injections by the central bank do not lead to an increase in spending or investment. In a liquidity trap, companies and households prefer to hold their money in liquid assets (cash or bank deposits) instead of spending or investing it, even if interest rates are close to zero. This leads to stagnation in the economy as demand for goods and services does not increase sufficiently. A liquidity trap can have serious economic consequences that need to be addressed through a combination of monetary and fiscal policy and structural reforms.
| Consequence | Description |
|---|---|
| Economic stagnation | Despite low interest rates, demand remains low, leading to low economic growth or even recession. |
| Effectiveness of monetary policy | The central bank's ability to stimulate the economy by cutting interest rates is severely limited. |
| Deflation | Persistently low or falling prices, leading to further restraint in spending and investment. |
| Increased savings rate | Households and companies save more as they see no attractive investment opportunities, which further dampens demand. |
| Unemployment | Low demand may force companies to cut jobs, which increases unemployment. |
| Company insolvencies | Companies that rely on credit could run into difficulties as banks are less willing to lend. |
| Falling investment | Companies invest less in new projects or expansion, which inhibits economic growth in the long term. |
| Social tensions | Persistent economic problems can lead to social tensions and political instability. |
| Currency devaluation | Can lead to a devaluation of the currency, which increases import costs and can import inflation. |
First-degree liquidity, also known as the cash ratio, measures a company's ability to settle its current liabilities immediately with its available liquid assets (cash and bank balances). This ratio provides a quick overview of the company's immediate solvency. A typical guide value is between 20% and 50%.
Second-degree liquidity, also known as the quick ratio or acid test ratio, extends the analysis to include short-term receivables in addition to cash and cash equivalents. This ratio shows the extent to which the company is able to cover its current liabilities with cash and cash equivalents and receivables that can be collected quickly without having to rely on the sale of inventories. A value of at least 100% is considered healthy and indicates that the company can sufficiently cover its current liabilities.
A typical guideline value for 1st degree liquidity is between 20% and 50%. This means that a company should ideally be able to cover at least 20% to 50% of its current liabilities immediately with available liquid funds (cash and bank balances).
The 3rd degree liquidity, also known as the current ratio, indicates the extent to which a company is able to cover its current liabilities with its total current assets (cash and cash equivalents, current receivables and inventories). A value of 1.5 to 2 is considered healthy as it shows that the company has sufficient current assets to cover its current liabilities.
Ideally, the 3rd degree liquidity should be between 1.5 and 2. This shows that the company has sufficient current assets to cover its current liabilities and is therefore financially healthy and stable.
First-degree liquidity may be less than 100% because companies do not have to cover all current liabilities immediately with cash and bank balances. They also have other current assets such as receivables and inventories that can contribute to covering liabilities.
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