Your first job is to stay in business. To stay in business you have to pay your bills. If you don’t, you will waste a lot of time returning phone calls from your unpaid suppliers and the bank whose interest is overdue. If they don’t like what you say, they will stop supplying and lending. If you don’t satisfy them after this, they will put you into bankruptcy.
What is Liquidity?
Liquidity measures your ability to pay your bills. It can be very quickly calculated from your financial statements.
Plus
- Cash
- What your customers owe you
- Inventory (unsold products, unused supplies, services you have performed but haven’t yet sent a bill)
Minus
- Loans you must repay within 1 year
- What you owe your suppliers
Equals
- Your Liquidity.
If your liquidity is positive, you should be able to pay your bills. If it isn’t, you likely can’t. It is that simple.
In measuring your liquidity, you have to be careful of two things.
Are Your Receivables Good Receivables?
When you sell something or provide a service to a customer and they don’t pay by cash or credit card, you become their lender. Before you become their lender, you need to be comfortable they are good for the money. If you don’t know them personally or by reputation, get them to pay cash or by credit card. If you are selling them a service, get them to pay something up front. If they refuse, move on to the next customer.
If you have satisfied yourself that a potential customer is a good risk, set industry standards terms for how long they have to pay you after they have received your bill. 30 days is the norm. In practice, 45 days is a good target for your average bill to be paid.
Even good customers can have problems. These problems usually show up in slow payment of bills. Your accounting package will allow you to break your receivables down by how long they have been unpaid. Anything unpaid for more than 60 days is a flag, more than 90 days a problem, and more than 120 days a write-off. Customers who take more than four months to pay a bill usually won’t or can’t pay it.
To avoid inflating your liquidity, exclude all receivables over 90 days. Turn yourself into a bill collector for any more than 60 days old.
Is Your Inventory Good Inventory?
How long has a product been in inventory? If you haven’t sold it in a reasonable time, it may not be saleable. You need to set a shelf life for your products which represents a reasonable time for them to sell. Any goods you have on hand which are older than this need to be checked to make sure they are still saleable. If there is doubt, don’t fool yourself. Don’t consider them in your liquidity calculation.
Protect Your Liquidity
More potentially good young businesses die in the cradle because the owners don’t take care of liquidity. The bank gets nervous or the supplier stop supplying and suddenly your oxygen tank is empty. Don’t let this happen.
We will talk in a later post about how to raise the capital you need for your business.
Posted by tedcape 