Meaning of Liquidity

Liquidity is the ability to make payments on time . Anyone who is not liquid can only pay due claims late or, in the worst case, not at all, which leads to bankruptcy.

Definition of liquidity

According to Electronicsmatter, liquidity is necessary in order to make payments on time. Put simply, this means that the company has enough financial resources to pay all the bills . Accordingly, liquidity is extremely important, because unpaid claims lead to ever greater financial difficulties, including insolvency and filing for bankruptcy .

Liquidity ratios and calculation of liquidities

Given the great importance of liquidity, it is important to keep an eye on it at all times. You can not just look at the account balance, but also calculate various liquidity ratios. Let’s take a closer look at these three key figures.

1st degree liquidity (cash ratio)

This metric gives a quick insight into whether the company is able to make upcoming payments on time. Here the short-term liabilities are set in relation to the currently available liquid funds.
The formula is accordingly:

(Cash) / ( Current Liabilities) x 100

“Liquid funds” are primarily understood to mean bank and cash balances. Short-term liabilities are all liabilities that are due within the next 12 months, plus tax provisions and other provisions relating to the period.
It is important that the short-term liabilities do not have to be completely covered by cash. For example, if a company itself has outstanding receivables that will be settled shortly, the liquid funds do not have to cover the short-term liabilities in full.

2nd degree liquidity (Quick Ratio or Acid Test Ratio ATR)

The difference to first-degree liquidity lies precisely in the short-term receivables already mentioned. In the case of second-degree liquidity, this is added to the liquid funds.
The formula is accordingly:

(Cash + short-term receivables) / (short-term liabilities) x 100

The desired result is of course above 100 , so that it is clear that the liquid funds and the open, short-term receivables that should lead to incoming payments within the next 12 months are greater than the short-term liabilities.
At the same time, the value should not be too high, because a value above 120 can indicate risks, such as poor cash management.

3rd degree liquidity (current ratio)

In the case of third-degree liquidity, inventories are now added in addition to liquid funds and short-term receivables. This sum is put in relation to the short-term claims. The formula is therefore:

(Cash + short-term receivables + inventories) / (short-term liabilities) x 100

The result should be over 120 , but also significantly higher. A result of 125 would show, for example, that the company can fully cover its short-term liabilities and that short-term receivables are used in addition to cash and cash equivalents and that there are also inventories that can be sold.

A significantly higher value would indicate that there is either a lot of unused funds, high outstanding receivables, or large inventories, which can indicate poor sales and is associated with high storage costs. The consequences of excessively high results will also be discussed in detail in a later paragraph (“Consequences of excessively high liquidity”).

What are the consequences of a lack of liquidity?

If there are not enough financial resources to settle claims on time, the consequences of this will occur gradually. At the beginning, payment delays will lead to reminders , which in turn are associated with additional costs and high interest. At the same time, bank charges are also incurred if additional financial resources are raised here to ensure liquidity.

It becomes threatening when suppliers are no longer willing to wait for payments due. In these cases, they can end the collaboration, which can lead to delivery problems for your company . Alternatively, suppliers may only deliver against prepayment, which further exacerbates the liquidity situation.

In the event of a short-term inability to pay receivables on time, one can speak of a liquidity bottleneck . However, if these problems persist, it is considered insolvency . This means that the company is on the brink of failure and bankruptcy occurs.

And what happens if the liquidity is too high?

Can a company have too much money? The answer is yes, namely whenever it is idle. With regard to the three degrees of liquidity, we have already seen which factors are important: liquid financial resources, short-term receivables and inventories.

(Too) high liquid funds

A large number in the company’s bank account seems gratifying at first glance – but bank balances hardly earn any interest. Therefore, high liquid funds can also be an indication that the company sees no investment potential to drive its own growth. For example, excessively high liquid funds can be viewed negatively, as the capital is available but is nowhere used profitably.

(Too) high short-term claims

High short-term claims are in themselves pleasing as they indicate good sales figures. In this context, however, one should also look at historical data on payment defaults to check whether there are any risks here. A strict dunning system also helps ensure that short-term receivables really become incoming payments.

(Too) high stocks

Stocking is generally expensive, so the turnover here should be as large as possible. Lots of stocks can be an indication of poor sales . The stocks differ from one industry to another, which is why they have to be viewed individually depending on the company (e.g. perishable goods, etc.).
The various factors should always be viewed as a whole. In this way you can very quickly get a good picture of where there is potential for improvement.

Ensure solvency

Liquidity planning

Solvency is ensured primarily through good liquidity planning .

Liquidity planning is part of the company’s financial plan. All payment flows are mapped here, so that you can see at a glance which liquidity is available and when. The aim of liquidity planning is to know in advance which liquid funds will be available at what point in time. In this way, it can also be recognized on which days there may be liquidity bottlenecks. Corresponding measures can then be taken, e.g. strict receivables management or a short-term deferment of payment by a supplier in order to counteract the bottlenecks at an early stage.

Liquidity forecast

In the liquidity forecast, liquidity planning takes place in a clear form on a monthly basis.

The preview shows which incoming and outgoing payments there will be in the relevant month and which surplus or deficit is expected. This rough plan can be created for several months in advance and continuously adjusted.

Measures to increase liquidity

Various measures can be taken to strengthen the company’s liquidity.

Capital release – factoring

Factoring is the technical term for the sale of accounts receivable . Specifically, this means that your customers have a payment term of 60 days, for example, but you will receive the money from the factoring bank for a corresponding fee immediately after billing. In this way, your incoming payments move forward, but also decrease slightly.

Retention of profits

The retained earnings improved liquidity. Always note, however, that retained earnings can also be interpreted in such a way that there are too few options for you to invest in growth activities. So build up enough liquidity to be able to lead the company stably and safely even through bad times, but do not reinvest profits in endless amounts.

Capital increases

In the case of capital increases, for example, new shares can be issued or company shares sold. The capital flows directly into the company and can secure liquidity. This measure does not usually play a major role in smaller companies.


Solid liquidity is a prerequisite for any successful company . Otherwise, relationships with suppliers can suffer and threatening situations arise. Always make sure to maintain good relationships with your suppliers and banks so that you have a good basis for discussion in the event of temporary payment difficulties.

So that it doesn’t get that far in the first place, you should invest enough time in realistic liquidity planning, because this way you can identify possible bottlenecks at an early stage and use your capital sensibly.