A company's liquidity: what it is and how it is calculated.

There are several ratios and formulas that help in understanding how businesses are performing, their viability, and their financial health. One of those indicators is working capital (capital circulante).

You have probably heard the phrase “that company has liquidity problems” countless times. Or “that company had to close due to a lack of liquidity.” But do you really know what it means? Or, rather, do you know what it implies?

Below, we explain what a company's liquidity is, what it means to have a shortage or an excess of liquidity, and, above all, how it is calculated.

What is working capital?

To explain what a company's liquidity is, we must first clarify one point: liquidity and solvency are not the same thing.

These are two concepts that tend to go hand in hand, which is why many people tend to confuse them. But there is a nuance that sets them apart. Let us look at the meaning of each:

• Solvency. Solvency is understood as the ability to meet all financial obligations over a long period of time.

• Liquidity. This represents a company's ability to convert its assets into cash quickly and without incurring a significant loss of value.

As you can see, solvency is a concept associated with the long term, and liquidity with the short term. Nevertheless, both refer to the company's financial commitments and resources.

All of a company's assets and rights that can be converted into cash in less than one year (which could be described as short-term) are what is known as working capital or current assets.

Generally, they are characterized by being used in the production process and incorporated into the final product. A good example would be the raw materials needed to produce a particular good. In the case of a publishing house, the paper and ink needed to print books would be one of the most important components of its current assets.

Working capital is the difference between a company's current assets and its current liabilities.

It represents the amount of resources a company has at its disposal to finance its day-to-day operations and meet its short-term obligations. In other words, it is a financial indicator that reveals the company's liquidity.

How is it calculated?

Before calculating working capital, you need to know the composition of the company's balance sheet, which is divided into assets and liabilities (both must add up to the same amount).

• The assets side includes assets and rights such as fixed assets, financial investments, merchandise, and cash. It is in turn divided into non-current assets (long-term) and current assets (short-term).

• The liabilities side includes all obligations, such as amounts owed to creditors or debts. It is divided into equity (capital and reserves), non-current liabilities (long-term debts), and current liabilities (short-term debts).

With this in mind, the calculation is straightforward: Working Capital = Current Assets – Current Liabilities.

Here you can see more clearly that working capital refers to the short-term resources a company uses to finance its day-to-day operations and keep running. It is vital to ensuring the company's survival in the short term.

Characteristics of working capital

Current assets are an essential element in the financial structure of any company. They are a company's short-term financial pulse, providing the agility and solvency required to meet commitments and ensure smooth day-to-day operations. In addition, they have the following other characteristics:

• They are used to repay short-term loans.

• They can be converted into cash in less than twelve months.

• They cover the expenses of the company's normal operations.

• They must also cover debts that customers have not yet paid.

• They include raw materials held in inventory and products that are already ready to be sold.

• Cash on hand and in banks forms part of these assets.

Accounts that make up working capital

The accounts that form part of current assets are set out in the Spanish General Chart of Accounts (Plan General Contable), and their main asset components are the following.

• Cash or cash on hand. This is the money the company holds on hand and in banks to meet its outstanding payments.

• Inventories. These are the raw materials needed for production and the finished products made by the company.

• Short-term financial investments. That is, financial products with a maturity of less than one year. In this case, this could be a deposit.

• Short-term receivables. These correspond to the amounts owed to the company as creditor.

Why is this financial indicator so important?

This indicator makes it possible to gauge the health of the business and to take action to ensure the company's viability.

The concept of working capital is essential to understanding the viability of the business. This information shows how much money will be available over the coming months. Managing these figures properly will help ensure sound liquidity management.

In addition to all of this, it is also key to understand that working capital often relies on net working capital (fondo de maniobra), a concept that encompasses the long-term financial resources that enable a company to maintain the continuity of its activity in the short term.

Accordingly, it is also useful for gaining a clearer picture of the company's financial health in the short term.

Net working capital can be calculated by subtracting current liabilities from current assets or working capital. Net working capital may also be positive or negative. The differences are as follows.

• When net working capital is positive, current assets exceed current liabilities. This indicates that the company can meet its short-term debts and is a clear sign that the company is in a good financial position.

• When net working capital is negative, current liabilities exceed current assets, which means there is a lack of liquidity. This shows that the company does not have sufficient short-term assets and has difficulty meeting its debts falling due in the near term.

What to do if a company lacks liquidity

After carrying out the above analyses, it may turn out that the company has either a shortage or an excess of liquidity. Neither situation is at all encouraging.

Let us look at how to address the first. A lack of liquidity in a company is one of the most complex issues. However, before you panic, you should know that the values we mentioned earlier for the liquidity, acid-test, and cash ratios are subject to variation.

Everything depends on your sector and the actions you have recently taken. That said, if you know how a company's liquidity is measured, you will have no trouble interpreting the results.

For example, suppose you have just made all outstanding payments to suppliers. Most likely, your liquidity will not be at its most comfortable. But this is not a cause for concern; it is natural! And you should bear it in mind.

However, once you have calculated your cash liquidity ratio, you should ask yourself: Can I meet my most immediate commitments? If the answer is no, there is most likely a reason for it. Falling sales, shrinking product margins, or poor financial planning are clear triggers. In this case, the ideal course of action would be to carry out an in-depth diagnosis of the situation in order to identify the source of the problem and resolve it.

And what if there is excess liquidity?

Some business owners think that liquidity problems are always due to a lack of it. However, having excess liquidity is also a drawback for the company.

This situation, like the previous one, stems from poor financial management. In other words, if a startup has more resources than short-term commitments, it is because those resources have not been invested efficiently. The solution? Make smart investments or reward shareholders through a dividend distribution.

As you can see, there are many decisions that must be made in a startup or company to keep everything in order in financial terms.