Confused About Liquidity Ratios? Here’s What You Should Know
As every startup matures, their profits and liabilities change. With engineering and technology needs, office space and talent, founders need a financial measurement to show their dedication to financial responsibility and growth trajectory to investors — especially at later stages. Part of this requires leaders to work with their finance teams to understand and optimize their liquidity ratios.
Why is a liquidity ratio so important? What should your business target as their liquidity ratio? While more important for later stage companies, by understanding this crucial measurement, founders can make the critical decisions to drive their business into its next evolution.
Liquidity Ratios & Your Company
Unlike a solvency ratio, the liquidity ratio measures a startup’s ability to pay immediate and short-term liabilities. Liquidity is a measurement of how current assets are converted to cash, which are then used to pay immediate payments and invoices due. A startup with strong liquidity will have enough cash on hand to pay liabilities due within one year or less, with enough left over to cover unforeseen or urgent needs.
There are a couple ways startups can determine their current liquidity ratio. One method involves dividing current assets against current liabilities off of your balance sheet. The result is a quick comparison of how much money is available for immediate usage. Another way to measure liquidity is to divide the difference of current assets and inventory against current liabilities. For startups that sell physical products, this can be the preferred way to understand liquidity against potential sales ready to be fulfilled. This is an especially useful view for D2C and other inventory style business models.
Why Does Your Liquidity Ratio Matter?
For startups looking to join a venture capital portfolio, the liquidity ratio is just one of the many important measurements they can present. As a quick overview, liquidity shows an executive team’s ability to manage their debt and liability, giving insight into how the company could grow. This becomes critical as companies progress to later stage funding rounds, which typically include some debt.
More importantly, the liquidity ratio demonstrates how viable a business is in their industry. Combined with other measurements, liquidity ratios can show that a startup is healthy, has a sound growth strategy, and can expand into a much bigger business with additional capital.
What Should Be Your Target Liquidity Ratio?
Because startups are often breaking new ground and driving results in new directions, there is no one target liquidity ratio every business should aim for, but in most cases being more liquid looks better to investors, markets, and potential partners. Being too liquid can be a problem, but contrary to popular opinion, you don’t always need to take death-defying risks when you’re looking to grow. Ideal ratios can vary from business to business and industry to industry. As a general rule, stronger ratios can instill confidence in investors, giving them strong evidence to trust your team with their resources.
Your liquidity ratio can also be a measure of how responsible your business is with day-to-day finances. To attract the best investors and mentors, startups should strive to have a liquidity ratio between 1.5 and 2 to 1. This tells interested investors that you have at least 50 percent more cash on hand than the startup’s current liability load. This measurement suggests to outside parties that your business is being responsible with assets, and is working hard to ensure long-term viability.
Turn to the Experts to Get the Right Ratio
As with any financial measurement, liquidity ratio is just one of many considerations potential investors will want to review. Debt-to-income ratio, burn rate, and recurring income measurements may all be called upon as venture capitalists decide to partner with any startup.
Founders are best at creating the next generation of goods and services, not necessarily finances. When making long-term plans, turn to an expert who specializes in helping small businesses meet and exceed their potential. airCFO has the insight and expertise on how startups can maximize their possibilities, and chart a path towards success. Start a conversation with us today, and let’s discuss how to turn your vision into a reality.