What is liquidity?

Liquidity refers to a company's ability to meet short-term payment obligations. Most businesses carry liabilities, such as loans, that require regular repayments.

When a payment is due, the company must settle it immediately. If it can do so reliably and on time, its liquidity is strong – keeping creditors satisfied.

What is liquidity ratio?

The liquidity ratio is a financial metric used to assess a company's ability to meet its short-term obligations using its most liquid assets. It compares a company’s liquid assets, like cash and receivables, to its short-term liabilities, like debts due within the next 12 months.

A common liquidity ratio is the current ratio, which is calculated as: Current Ratio = Current Assets / Current Liabilities

A ratio greater than 1 indicates that a company has more assets than liabilities and is in a relatively good position to cover its short-term obligations. A ratio less than 1 may suggest liquidity problems, meaning the company may struggle to pay its debts when due.

Liquidity analysis: methods and approaches

There are different ways to assess liquidity. The key is to determine the perspective from which you analyze it. First, the essential terms:

• Absolute liquidity
• Relative liquidity
• Static liquidity
• Dynamic liquidity
• Artificial liquidity
• Natural liquidity

Absolute liquidity

Absolute liquidity measures how much cash a company actually has: cash on hand, physical currency, and bank balances. It indicates how quickly funds are available and how easily the company can access liquid assets. The analysis focuses on how efficiently assets can be converted into cash.

Relative liquidity

Relative liquidity measures how well a company can cover its short-term liabilities with liquid assets like cash or bank deposits. The higher the ratio, the more flexibility a company has to make payments.

There are also liquidity ratios that assess whether a company meets its payment obligations on time. These are classified into three levels:

Liquidity ratio 1: cash liquidity

Liquidity 1 measures how well a company can settle debts using only cash, bank deposits, or checks. The formula:

(Cash & equivalents / short-term liabilities) × 100

Cash equivalents include physical cash, bank balances, checks, and discountable bills. Short-term liabilities cover debts and provisions due within a year.

A target value of around 20% ensures a company can meet its short-term obligations on time.

Liquidity ratio 2: short-term liquidity

Liquidity 2 extends the scope by including short-term receivables – amounts expected to be collected soon. The formula:

(Cash & equivalents + short-term receivables) / short-term liabilities × 100

Receivables include outstanding payments due within a year. Other components remain the same.

A target value of around 100% ensures a company has enough liquid assets and incoming payments to meet its obligations.

Liquidity ratio 3: medium-term liquidity

Liquidity 3 includes cash, receivables, and inventories – goods that can be sold to generate liquidity. The formula:

(Cash & equivalents + short-term receivables + inventories) / short-term liabilities × 100

Inventories refer to stock listed in the balance sheet. Other components remain unchanged.

The target value is above 120%. Why more than 100%? Because a company that sells all its current assets will have nothing left to produce new revenue. Liquidity 3 also aligns with the golden balance rule, ensuring a solid financial foundation.

Static liquidity

Static liquidity measures a company’s ability to pay its short-term obligations at a specific point in time – such as the balance sheet date. It includes first-, second-, and third-degree liquidity ratios, comparing available funds to short-term liabilities. Since it does not account for future cash flows, it remains unchanged over time. In short, it is a snapshot.

Dynamic liquidity

Dynamic liquidity, in contrast, tracks how a company’s financial position evolves over time. It factors in future cash flows and depends on the timing of income and expenses. In essence, it reflects cash flow trends.

Methods for measuring dynamic liquidity

Cash flow analysis

A cash flow analysis examines the movement of money in and out of a business. It reveals whether daily operations generate enough funds to cover expenses. Key components:

• Operating cash flow – Revenue from core business activities minus operating expenses.
• Investing cash flow – Cash flows from asset purchases or sales.
• Financing cash flow – Funds from loans, investments, or capital increases.

Liquidity planning

Liquidity planning involves forecasting future income and expenses to identify potential shortfalls early. This allows for proactive adjustments. A common approach is the 13-week liquidity forecast.

Natural liquidity

Natural liquidity comes from a company’s own earnings: revenue from selling products or services. Since it stems directly from business operations, it is sustainable and reliable.

Artificial liquidity

Artificial liquidity refers to short-term funds from external sources, without underlying revenue or cash flow. Examples include selling fixed assets originally meant for production or securing short-term loans. Such measures often serve as a temporary fix, artificially inflating liquidity to cover shortfalls.

You know the key terms for analyzing your company’s liquidity. The definitions depend on whether you’re looking at liquidity at a specific moment (static), over time (dynamic), or distinguishing between actual cash and funds generated on short notice (natural vs. artificial). Each term highlights a different perspective – measurement, assessment, or origin. In short:

• Absolute liquidity: how much cash is available immediately.
• Relative liquidity: a company’s ability to cover short-term debt.
• Static liquidity: a snapshot of liquidity at a given moment.
• Dynamic liquidity: how liquidity develops over time.
• Artificial liquidity: created through external financing.
• Natural liquidity: generated by the company’s own revenue.

Liquidity analysis: practical examples

Theory is useful – but only if you can apply it. Below are real-world examples of liquidity analyses, each considering different business situations and perspectives.

Example 1: liquidity analysis of an early-stage company

Company profile

• Industry: Software-as-a-Service (SaaS)
• Financial status: high initial expenses for R&D and marketing, but no significant revenue yet.

Liquidity analysis

Absolute liquidity

• Cash Reserves & Bank Balance: the company starts with €50,000 in cash and in its business account – enough to cover three months of operating costs (e.g., salaries, rent, and software licenses).
• Conclusion: liquidity is solid but only for the short term.

Relative liquidity

• Short-term liabilities: the company has €25,000 in outstanding short-term debts (e.g., unpaid invoices for cloud services).
• Liquidity ratio (cash ratio):
  
  • Formula: (Cash / Short-Term Liabilities) * 100
  • (€50,000 / €25,000) * 100 = 200%
• Conclusion: the company has enough liquid assets to cover short-term liabilities with ease.

Dynamic Liquidity

• Cash flow analysis: with no steady income yet, the company relies on external funding (e.g., venture capital) to cover ongoing costs.
• Conclusion: no operational cash flow yet, but liquidity is secured through outside financing.

Natural liquidity

• Revenue from operations: since the company has yet to generate meaningful income from software license sales, natural liquidity remains low.

Artificial liquidity

• External financing: to bridge short-term liquidity gaps, the company relies on equity financing. This is a temporary fix until the first paying customers come in.

Example 2: liquidity analysis of a mid-sized manufacturing company

Company profile

• Industry: Mechanical Engineering
• Financial status: the company has stable revenues but fluctuating expenses due to seasonal production peaks and investments in new machinery.

Liquidity analysis

Absolute liquidity

• Cash and Bank Balances: the company holds €500,000 in cash and bank deposits – enough to cover several months of operating costs.
• Result: strong absolute liquidity. The company has sufficient funds to meet short-term obligations.

Relative liquidity

• Quick ratio (Liquidity Ratio 2):
  
  • Formula: (Cash + Short-Term Receivables) / Short-Term Liabilities * 100 (€500,000 + €200,000) / €300,000 * 100 = 233%
  • Result: the company has enough liquid assets and receivables to cover all short-term liabilities.

Dynamic Liquidity

• Cash flow analysis: the company generates a stable operating cash flow of €150,000 per month from machine sales. However, revenue fluctuates due to seasonal demand
• Result: careful liquidity planning is essential to bridge months with fewer incoming orders.

Liquidity planning

To avoid shortfalls during lower-revenue months, the company develops a 12-month liquidity plan. The analysis reveals a €100,000 liquidity gap in the summer when demand drops. A short-term credit facility could serve as a buffer.

Natural liquidity

Revenue from operations is sufficient to maintain stable and sustainable liquidity.

Artificial liquidity

During periods of irregular orders, the company uses a €200,000 short-term credit line to cover production peaks.

Example 3: liquidity analysis of a large retail company

Company profile

• Industry: Retail
• Financial Status: the company has a broad customer base and strong revenues. Its financial structure is stable, but significant investments are tied up in inventory and receivables.

Liquidity analysis

Absolute liquidity

• Cash and bank balances: the company holds €5 million in liquid assets and maintains solid banking relationships.
• Result: absolute liquidity is well above average, ensuring the company can meet its payment obligations at any time.

Relative liquidity

• Mid-term liquidity (Liquidity Ratio III):
  
  • Formula: (Cash + short-term receivables + Inventory / short-term liabilities) * 100 = (5.000.000 EUR + 3.000.000 EUR + 2.000.000 EUR / 4.000.000 EUR) * 100 = 250%.
  • Result: the company has more than enough funds to cover its short-term liabilities. However, a large share is tied up in inventory and receivables, requiring efficient management.

Dynamic liquidity

• Cash flow analysis: operational cash flow is strong and stable, driven by consistently high sales. However, inventory financing and receivables management require ongoing liquidity planning.
• Result: operating cash flow is sufficient to meet financial obligations, but capital tied up in inventory poses a potential short-term liquidity risk.
• Liquidity planning: to smooth out seasonal fluctuations, the company follows a detailed liquidity plan that accounts for working capital needs and inventory financing.

Natural liquidity

Most liquidity comes from operational business, particularly recurring retail revenues.

Artificial liquidity

The company relies little on artificial liquidity, except for temporary shortfalls covered by existing credit lines.

These examples illustrate how liquidity analysis varies depending on company size, industry, and financial structure. A company’s liquidity is shaped by multiple factors: available cash, the ability to cover short-term liabilities, and efficient receivables and inventory management.

A thorough assessment of all liquidity types – absolute, relative, static, dynamic, natural, and artificial – is essential to safeguarding financial stability. You now understand how to conduct a liquidity analysis, both in theory and practice. What goals can you achieve with it?

The goals of liquidity analysis

The primary goal of liquidity analysis is to ensure your company’s solvency. It guarantees that you always have enough funds to meet your financial obligations. At the same time, it helps avoid unnecessarily tying up capital or incurring excessive financing costs.

But liquidity analysis can serve additional purposes:

• Avoiding liquidity shortages: by forecasting ahead, potential financial shortfalls can be identified early and avoided.
• Optimizing capital allocation: effective liquidity management reduces unnecessarily locked-up capital and strengthens the financing structure.
• Increasing financial flexibility: with solid liquidity planning, a company can act strategically, use credit effectively, and manage investments more efficiently.
• Reducing financing costs: proper liquidity control helps avoid expensive emergency funding or short-term loans with high interest rates.

Challenges with liquidity analysis

A liquidity analysis requires careful and precise execution. Only by doing so can you avoid risks or draw the wrong conclusions. It is crucial to view liquidity as a comprehensive topic, analyzing it from various perspectives, including both long-term and short-term factors.

What mistakes should you avoid in liquidity analysis?

Narrow focus on current liquidity

• Mistake: only considering the current liquidity (absolute liquidity) and ignoring future cash flows or dynamic liquidity.
• Consequence: you may overlook potential future obligations that could cause financial strain, even if the company appears liquid today.
  
  

Neglecting seasonal fluctuations

• Mistake: failing to account for seasonal revenue variations or periodic liquidity gaps caused by cyclical income and expenses.
• Consequence: a company may appear liquid during calm periods but could suddenly face payment issues in a weaker season.
  
  

Overlooking long-term liabilities

• Mistake: focusing exclusively on short-term liabilities while neglecting long-term financial commitments.
• Consequence: by concentrating too much on short-term liquidity, a company may lose sight of its long-term solvency and obligations.
  
  

Ignoring unexpected expenses

• Mistake: not setting aside reserves or contingencies for unexpected costs or emergencies.
• Consequence: a sudden financial pinch or unforeseen event (e.g., unexpected investments or market shifts) can push the company into a liquidity crisis.
  
  

Inadequate planning for long-term investments

• Mistake: moving forward with long-term investments or expansion plans without proper liquidity planning.
• Consequence: the company could face financial instability if it hasn’t reserved enough funds for the execution of long-term projects or investments.
  
  

Neglecting internal cash flows

• Mistake: failing to analyze internal cash flows in detail, such as when customers pay and when suppliers need to be paid.
• Consequence: this can lead to incorrect assumptions about how quickly liquidity is available and whether payment flows could cause delays.
  
  

Misinterpreting financial metrics

• Mistake: relying on inaccurate or misunderstood metrics, such as placing too much emphasis on a single figure like the cash conversion cycle.
• Consequence: by selecting the wrong or incomplete metrics, a company may gain a distorted view of its liquidity position.

Liquidity analysis with re:cap

With re:cap’s liquidity management software, you can conduct a comprehensive liquidity analysis. This includes:

• Dashboard: a real-time overview of your cash position, including all accounts, transactions, and balances.
• Cash flow statement: customizable at the project and team level, enabling you to track your cashflow in detail.
• Bank transaction categorization: our AI categorizes transactions with 98.8% accuracy, learning from your decisions.
• Runway analysis: see your cash burn rate and how long your funds will last.
• Liquidity forecasts: plan your liquidity and adjust parameters to project how your cashflow will evolve in the future.

Conclusion: analyzing liquidity is essential for businesses

Liquidity analysis is an indispensable tool for any business. It helps assess financial solvency and allows for proactive financial planning. By tracking available funds, analyzing liquidity in relation to liabilities, and considering dynamic cash flows, businesses can effectively manage potential risks.

It’s crucial that liquidity analysis is conducted carefully and comprehensively. Errors, such as neglecting long-term liabilities or relying too heavily on short-term financing, can distort a company's true liquidity picture. A solid liquidity analysis requires accurate data and must account for seasonal fluctuations, internal cash flows, and external funding sources.