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Liquidity – What Does This Mean?

In business, liquidity is defined as the period of time it takes to turn assets into cash.  It takes 20 minutes to turn the balance in the checking account into cash.  You head on down to the bank and present a check.  You get cash. 

But most businesses run on just more than the cash in the bank account.  You need fixed assets to produce goods or provide services.  At times you need to extend credit to you customers.  You have to purchase supplies or inventory to have something to sell.  Often you have to make large investments into research or the purchase of some non-physical asset such as goodwill.  

Each of these different types of assets takes time to turn into cash.  It is not as simple as going down to the bank and cashing a check.  This article identifies the customary amount of time it takes to turn the respective asset groups into cash. 

There are five major groups of assets in most businesses.  They consist of cash, inventory, receivables, fixed assets, and other assets.  The following explains the typically amount of time it takes to turn these resources into cash.

Cash & Cash Equivalents

This one is the easiest to turn into cash.  Just stand in line at the bank.  However, we still consider checks received from customers as cash on the books.  So there might be a delay of a few days if the bank puts those checks on hold.  So the reality is that cash means from 20 minutes to as long as 3 days.

Cash equivalents means stocks or bonds or some sort of paper backed by an exchange listed company or the government.  To turn these into cash, it typically takes no more than five days.

Inventory

Not as simple as cash, but close.  Depending on the nature of your business, inventory can be turned into cash is as short a period of time as a day to as long as several months.  Think about the variances.  If you sell hot dogs, you could turn your hot dogs into cash today, assuming you had enough customers.  However, if you have raw resources that have to be processed to create a product, well that’s a different story.  I once toured an electronic component manufacturing plant.  One of their components produced were capacitors.  Well a capacitor uses two conductors of electricity separated by an insulator of some sort.  In their case, the insulator was some form of clay.  Well they had a pallet load of 5 gallon buckets of this stuff.  It was a raw resource that they had paid cash to purchase.  It had a dollar value on the books of the company.  So it usually took about two weeks to turn this material along with other raw resources into capacitors.  Once made the capacitors were sold in lots of 10,000 units to different component assembly plants throughout the world.  Now the inventory was turned into a receivable.  In effect somebody owed them cash.  But this illustrates that inventory has a much wider period of time to turn into cash.  In accounting, the profession uses 30 days as the period of time to turn inventory into cash.

Receivables

Once the customer buys the inventory item, the company is either paid on the spot or credit is extended.   Typically, most businesses extend credit so a receivable is posted on the books.  Most customers pay in about 30 days from the time of the invoice.  Some take longer, the government and large non-profit organizations have arduous procedures to get a check issued.  So it is not uncommon to receive the money about 45 days after an invoice is issued.  So for receivables, the typical liquidity time is 7 to 45 days.

Fixed Assets

This one is much more complicated due to the nature of the fixed assets found in varying businesses.  If your company owns a van as one of the fixed assets, this can be sold in less than one day.  It will be sold at a discount, but it can be sold in one day.  But at the other end would be some form of manufacturing equipment that produces some specialized piece of a product.  How many potential buyers are there?  This could take years to sell.  Fixed assets sell for anywhere from 20% discount to as much as 90% discount contingent upon the nature of the equipment.  So it is important to understand that from the perspective of liquidity, fixed assets take from 60 days to a year to sell.  This is one of the more extended areas of liquidity.

Other Assets

There are very few buyers of goodwill unless they purchase the entire company as a whole.  Furthermore, there is a limited market for patents or industry research.  This is because any small business with this type of an asset has very few if any potential buyers.  Only the bigger organizations would be interested in these items.  Therefore, it takes a tremendous amount of time and work to find a buyer, no less get it sold.  Therefore, goodwill, patents, and/or research takes more than 6 months to sell.  These types of assets are also referred to as intangibles.

Notice from the above groupings, they are organized from the most liquid to the least liquid.  The key to liquidity is the ability to turn an asset into cash.  As a small business owner, if you are having to turn fixed or other assets into cash, you have some serious ongoing operation issues.  The key to business is to have assets in place to earn you money.  By properly combining personnel and equipment to produce the product or service, you are maximizing the opportunity to earn revenue.  And that is what business is all about.

So for the successful small businessman, liquidity has very little if any impact upon operations or the overall success of the business.  It should be nothing more than a term used in business related to the termination or discontinuation of operations.  Remember this – it is a part of terminating the business.  A small business entrepreneur is not in the business of getting out; he is in the business of making money.  This term is something that should not be in your vocabulary.  Act on Knowledge.

If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org.  I would love to hear from you. If interested in my services as an accountant/consultant; click on My Services in the footer of this article.

 

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About David J Hoare (380 Articles)
I spent 12 Years as a Certified Public Accountant, Over 20 Years of Practice in Accounting and Consulting, Controller in Management of Closely Held Operations, Masters of Science in Accounting, Prepared over 1,000 Business Tax Returns and Hundreds of Individual Returns

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