It’s not a secret at all: liquidity, meaning easily accessible funds, is essential for any company. But has anyone ever examined the reasons? We have covered how the heartbeat of the business bank account determines the financial health of a company. But what does it mean to have sufficient money in your bank account or cash register, and why is this a decisive factor?
Why liquidity is important
A company needs financial freedom of action. This means you must be able to pay your bills. If you cannot pay, you’re insolvent, also called bankrupt. To avoid this state, which often spells the end of a company, and remain solvent to pay your bills, liquid funds are a necessity.
Even if you grow economically, solvent companies are endangered. It may be that your customers will always pay their bills. But it’s a fact that some people wait until the last moment to do it, until the very due date. Anyone not having the luxury to delay their own payments, but obliged to pay immediately, will have a liquidity problem if their available funds are insufficient.
Turnover, payment, profit
Insolvency may be avoided most easily by creating a financial cushion. Only because your company is creating a revenue and turning a profit, it doesn’t mean it’s also solvent. The following example will explain this further.
Terry is the owner of an advertising agency. He just received a big request from a customer. For 20.000 Euro, he is to design a poster campaign and a matching radio ad. Terry starts immediately. During the production, he will have to cover some advance costs; this is not unusual in his trade. For the posters, he needs to pay the models, the photographer, the visual designer and the printing company; the radio ad requires a script, voice actors, studio and editing of the final audio tracks. The sum of all advance payments is 12.000 Euro.
The moment, Terry delivers the requested products, his company has made a turnover of 20.000 Euros, mathematically. This is denoted in the balance sheets, of course, as it is important for the annual balance.
However, with advance costs of 12.000 Euro and a turnover of 20.000 Euro, Terry’s actual profit is only 8.000 Euro. Still, looking at his bank account, he hasn’t made a single cent so far.
Unvoluntary lender
This is because Terry and his customer agreed on a 30 days payment period. And the customer is using the full time, paying on the last possible day. Until then, Terry’s advertising company needs to handle a financial gap of 32.000 Euro: Both the advance payments, as well as the still unpaid invoice to his customer, are inaccessible funds – money that Terry can’t actively use. Even more, he has granted his customer a very generous loan of 20.000 Euro – with no interest!
The only way to do business under such conditions is to have a financial cushion of sufficient size. Moreover, entrepreneurs like Terry will most likely not lean back until they receive the payment, as there are other bills to pay, for instance, office rent, working materials and employee wages. Also, they need to be able to make advance payments for any new jobs that may come in. Without sufficient liquidity, this is impossible.
The gushing springs of liquidity
It doesn’t matter if you need to buy a stamp, new raw materials for production, pay for a lunch or the salary of your employee – everything has its price. If you can’t pay your bill or advance expenses, you are unable to act as an entrepreneur. There are, however, several options to increase your working capital on short notice. One of these is prefinancing, which allows you to turn the invoices to your customers into available funds before the due date.
Learn more about how Finiata can help you avoid a financial gap on our website. Try it; we check you’re uploaded invoiced for eligibility for prefinancing and calculate your individual financing conditions – absolutely free and non-binding.
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