As a freelancer, it’s crucial to understand the liquidity ratio and how it can impact your financial health. The liquidity ratio measures your ability to repay short-term debts using your current assets. It helps determine whether you have enough cash flow to cover your expenses and maintain a healthy financial position.
You should know that maintaining good liquidity is crucial for your business, as irregular cash flows are expected in freelance work. This means you must have enough cash to pay bills, salaries, and other expenses without delay. By keeping a close eye on your liquidity ratio, you can ensure you have enough cash flow to meet your short-term liabilities.
Today, we will discuss what liquidity ratio means and how it impacts your business.
What is a liquidity ratio?
The liquidity ratio is a financial metric measuring your ability to pay off your current liabilities using your current assets. It’s a vital tool for measuring the financial health of your business and plays a crucial role in the decision-making process for investors, creditors, and other stakeholders.
What is liquidity and why is it important for your freelance business?
Liquidity refers to your assets that can be converted into cash quickly, which is essential for meeting your short-term financial obligations, such as paying bills and salaries, without delay.
If you’re running a freelance business, liquidity is crucial as you often have irregular cash flows and rely on quick client payments. You may have periods where you earn less, and it’s vital to have enough liquidity to cover your expenses.
On top of that, freelancers typically work on a project basis, meaning they often have to spend money upfront to complete the project and get paid later. Maintaining good liquidity ensures you can cover your expenses while waiting for payment from your clients.
Types of Liquidity Ratio
There are several types of liquidity ratios that businesses use to measure their ability to meet short-term financial obligations. Check them out below.
The current ratio is the most widely used liquidity ratio and is calculated by dividing a company’s current assets by its current liabilities. This ratio measures a company’s ability to pay off its short-term debts using its existing assets.
A higher current ratio may be indicative of your ability to meet short-term financial obligations. It’s calculated by dividing your current assets by your current liabilities.
The quick ratio (sometimes referred to as acid-test ratio) is a liquidity ratio that measures your ability to pay off your short-term liabilities using your quick assets, such as cash, marketable securities, and accounts receivable. It’s calculated using this formula: (current assets – inventory) / current liabilities.
The cash ratio measures your company’s ability to meet its short-term obligations using only its cash and cash equivalents. To calculate, divide your business’s cash and cash equivalents by its current liabilities.
How is Liquidity Ratio Calculated
Based on what you know about the different types of liquidity ratios, here’s how to compute them.
Computing Your Current Ratio
To calculate current ratio, divide your current assets by the current liabilities.
The formula is as follows:
Current Ratio = Current Assets / Current Liabilities
For example, if your freelance business has P100,000 in current assets and P50,000 in current liabilities, its current ratio would be:
Current Ratio = P100,000 / P50,000
Current Ratio = 2:1
This means the company has P2 in current assets for every P1 in current liabilities.
Computing Your Quick Ratio
The quick ratio is calculated by subtracting a company’s inventory from its current assets and dividing the result by its current liabilities.
The formula is as follows:
Quick Ratio = (Current Assets – Inventory) / Current Liabilities
For example, if your business has P100,000 in current assets, P20,000 in inventory, and P50,000 in current liabilities, its quick ratio would be:
Quick Ratio = ($100,000 – $20,000) / $50,000
Quick Ratio = $80,000 / $50,000
Quick Ratio = 1.6:1
This means the company has P1.6 in liquid assets for every P1 in current liabilities.
Computing Your Cash Ratio
To calculate the cash ratio, divide cash and cash equivalents by current liabilities.
The formula is as follows:
Cash Ratio = (Cash and Cash Equivalents) / Current Liabilities
For example, if your freelance business has P50,000 in cash and cash equivalents and P100,000 in current liabilities, its cash ratio would be:
Cash Ratio = P50,000 / P100,000
Cash Ratio = 0.5:1
This means that the company has P0.50 in cash and cash equivalents for every P1 in current liabilities.
Understanding marketable securities in relation to liquidity ratio
Marketable securities refers to financial instruments that can be easily bought or sold in the financial markets. These securities are considered highly liquid and can be quickly converted into cash without significant loss of value.
Analysts often consider the value of marketable securities when analyzing a company or sector’s liquidity ratios. These securities, along with cash ratios, are considered a company’s most liquid assets, and their value can indicate the company’s ability to meet short-term financial obligations.
Factors That Can Impact Freelance Business’s Liquidity Ratios
Liquidity ratios are essential for assessing a freelance business’s financial health, and several factors may affect it.
1. Accounts Receivable and Accounts Payable
The timing of client and vendor payments can impact a freelance business’s liquidity ratios. If clients are slow to pay or a business has a high level of unpaid invoices, it can affect its ability to pay off its bills and debts on time.
Conversely, if your freelance business has a lot of cash on hand but needs to pay its vendors on time, it can hurt its overall financial health.
2. Inventory Management
While inventory isn’t a factor for all freelance businesses, those selling physical goods must keep track of their inventory levels. If your business has too much inventory, it can tie up valuable cash that could be used to pay off debts. On the other hand, if your freelance business has too little inventory, it may struggle to fulfill orders and generate revenue.
3. Cash Flow
Cash flow, being the lifeblood of any business can help you determine if you have enough working capital to keep your operations running.
If your freelance business is generating a lot of revenue but isn’t managing its cash flow effectively, it can lead to a cash crunch that impacts its ability to pay off debts. Conversely, if your business is managing its cash flow well, it can improve its liquidity ratios even if it has a lot of outstanding debts.
Many freelance businesses experience seasonal fluctuations in revenue, which can impact their liquidity ratios. For example, if you generate most of your income during the holiday season, you may struggle to maintain good liquidity ratios during the slower months. Freelance businesses must plan for these fluctuations and manage their cash flow accordingly.
5. Economic Conditions
External factors like economic conditions can also impact your freelance business’s liquidity ratios. For example, during a recession or downturn, clients may be slower to pay or reduce their orders, which can impact your business’s ability to generate revenue and pay off debts.
6. Operating Expenses
Operating expenses are the costs incurred in running the business’s day-to-day operations. If your business has high operating expenses, it may impact its liquidity ratios, as it may need more cash to cover its short-term liabilities.
Ways to Improve Freelance Business’s Liquidity Ratios
As a freelance business owner, it’s important to maintain good liquidity ratios to ensure your business has sufficient cash on hand to pay its bills and debts. A low liquidity ratio can be a warning sign for your business and could impact its ability to borrow money or attract investors.
If your liquidity ratios are not as strong as you’d like them to be, you can use several strategies to improve them.
1. Keep Balance Sheet Updated
Maintaining an accurate and up-to-date balance sheet can help improve a business or company’s liquidity ratio by providing you with a clear understanding of its current financial position.
Balance sheets can help improve your business’s ability to determine its current assets and liabilities and whether it has enough liquid assets, such as cash or short-term investments. It can also help identify any excess or idle assets that can be sold to generate cash and improve liquidity.
2. Reduce Debts
One way to improve your liquidity ratios is by reducing your debts. Start by reviewing your debt obligations and prioritize paying off high-interest debts first. Consider negotiating with creditors to reduce the interest rates or to extend the repayment period to make the payments more manageable. On top of that, you can consolidate your debts into a single loan to simplify your payments and avoid delays.
3. Increase Cash Reserves
Increasing your cash reserves can also help you improve your liquidity ratio. You can do this by cutting unnecessary expenses or increasing your income by creating new revenue streams. Remember to review your budget and identify areas where you can cut costs without impacting the quality of your work.
For example, you can reduce your marketing expenses or negotiate better rates with your vendors. Increasing your income can also be achieved by taking on more projects, raising your rates, or diversifying your services.
4. Improve Cash Flow
Improving your cash flow is critical to maintaining good liquidity ratios. You can negotiate more favorable payment terms with your clients. Instead of waiting 30 or 60 days for payment, you can ask for payment upon project completion or within a shorter timeframe, such as 15 days. This will help you receive payments faster and improve your cash flow.
Another way to improve your cash flow is to diversify your client base. Instead of relying on just one or two clients for most of your income, you can work simultaneously with multiple clients and projects. This spreads out your income sources and reduces the risk of losing all your income if one client stops working with you.
5. Increase Sales
Increasing sales can improve the liquidity ratio in several ways. First, making more sales generates more revenue, which can be used to pay your current liabilities such as accounts payable, taxes, and short-term loans. This improves your liquidity ratio by increasing your current assets, which are the resources you have available to meet short-term obligations.
Aside from that, increasing sales can help you build a cash reserve. When you have more cash on hand, you can better manage unexpected expenses or fluctuations in revenue. This cash reserve can help you meet short-term obligations and improve liquidity ratio.
Here are some practical ways to increase sales:
- Know your target market: To increase sales, it’s important to know your target market inside out. Understand their needs, preferences, and pain points so you can create products or services that meet their specific needs.
- Improve your marketing: Consider using online and offline marketing tactics to reach your target audiences, such as social media, email marketing, SEO, and paid advertising.
- Offer discounts and promotions: Discounts and promotions are effective ways to attract new customers and incentivize existing ones to purchase. Consider offering limited-time discounts, free shipping, or bundle deals.
- Focus on customer experience: A positive customer experience can lead to repeat business and more referrals. Make sure your customers feel valued and satisfied by offering excellent customer service and responding to their feedback.
- Build partnerships and collaborations: Collaborating with other businesses can help you connect with new audiences and boost sales. Look for partnerships with complementary businesses or influencers in your industry.
6. Sell Assets
If your freelance business has assets that are not generating income, consider selling them to improve your liquidity ratios. Assets that can be sold include equipment, inventory, or property. Selling assets can free up cash that can be used to pay off debts or increase your cash reserves.
Selling assets can help reduce expenses associated with owning and maintaining those assets. For example, if you sell no longer needed equipment, you can save on maintenance and storage costs, improving your overall financial health.
7. Have Better Visibility on Your Finances
With improved finance visibility, you better understand your current financial position, including your cash reserves, outstanding debts, and upcoming expenses. This allows you to plan and manage your cash flow more effectively, ensuring you have the necessary resources to meet your short-term financial obligations.
For Filipino freelancers, the best way to have a bird’s eye view of your finances is by leveraging finance management tools like the Beppo App.
Beppo is a comprehensive financial management app designed specifically for online Filipino freelancers. With Beppo’s user-friendly interface, you can easily manage your finances and taxes all in one place, including invoicing, expense tracking, and tax calculations. By using Beppo, you can focus on your work while the app takes care of your financial management needs.
Read to take advantage of the Beppo app? Here’s how:
Step 2: Sign up using your email address and password.
Step 3: Fill out your personal information and upload a valid government- issued ID for verification.
Step 4: Upon account verification, head to the What’s New Banner and accomplish the form.
Improve liquidity ratio for long-term success
Improving your liquidity ratio is crucial to managing your freelance business’s finances effectively. By maintaining adequate cash reserves, managing your cash flow efficiently, and having a clear understanding of your financial position, you can ensure that you have the necessary resources to meet your short-term financial obligations and sustain your business’s operations in the long term.