There are probably many factors that act as a cornerstone of financial stability for any business. And you probably already know that a lack of liquidity can lead to missed opportunities for growth. But what is liquidity exactly, and why is it vital for merchants? Understanding this term can help a merchant make an informed decision to secure the financial health of their business and foster long-term success.
What Is Liquidity?
Whether it’s paying suppliers, covering employee wages, or handling unexpected expenses, a business needs to make sure it has the resources to function smoothly. This is even more vital for merchants. With daily transactions, refunds, and potential chargebacks to manage, having access to cash or quickly convertible assets can make or break their operations. A lack of such assets can lead to delayed payments and strained relationships with suppliers.
So, what is the definition of liquidity? When put in the context of finance, it represents the ease with which an asset can be turned into cash without materially altering its worth. Cash itself is the most accessible form, and it’s a benchmark for measuring how “liquid” other assets are. Different types of businesses rely on this financial flexibility to cover operational expenses, seize new opportunities, and address unexpected challenges.
Liquid and Illiquid Assets
Generally speaking, assets are classified as either liquid or illiquid based on how easily they may be turned into cash. Liquid assets, such as bank balances, publicly traded stocks, and accounts receivable, are readily accessible. These assets can be used to meet immediate obligations, and that’s what makes them invaluable for day-to-day operations.
On the other hand, illiquid assets require more time or effort to convert. Real estate, machinery, and specialized equipment are just some of the examples. While these often hold significant value, their conversion into cash is a lengthy process and may result in a loss of value during urgent sales.
For instance, a small business owner may have inventory worth thousands of dollars, but if it’s not selling quickly, it doesn’t provide the financial flexibility needed to pay suppliers or handle refunds. That’s why it’s essential to recognize that the balance between liquid and illiquid assets maintains a healthy financial position.
Understanding the Types of Liquidity
Liquidity can be viewed from different perspectives, depending on the context in which it is applied. For businesses – small or big, two primary types play central roles in financial stability and operational efficiency, and they include market and accounting liquidity.
Market Liquidity
This term refers to the ease with which an asset can be bought or sold in a market without causing a significant change in its price. In highly liquid markets, there is a large volume of buyers and sellers, which ensures that transactions can occur quickly and efficiently. For example, publicly traded stocks are considered highly liquid because they can usually be sold at market value within minutes during trading hours.
As for merchants, picture it like this – a product in high demand with consistent sales demonstrates market liquidity. This is because it can be turned into cash quickly at a stable price. On the other hand, a niche product with limited demand may require price reductions to sell.
Accounting Liquidity
Accounting liquidity measures a business’s ability to meet its short-term financial obligations using available assets. It focuses on the company’s internal cash flow management rather than external market conditions. Businesses with high accounting liquidity can easily pay off bills, loans, and supplier invoices without resorting to selling long-term assets.
Examples of such assets include cash on hand, accounts receivable, and inventory. For instance, if a merchant has sufficient cash and receivables to cover upcoming payroll or vendor payments, their accounting liquidity is strong.
Comparison of the Two Types
While market liquidity focuses on the broader ability to trade assets without price disruption, accounting liquidity is centered on a business’s internal financial stability. Both types are crucial for merchants, but they serve different purposes.
| Aspect | Market liquidity | Accounting liquidity |
|---|---|---|
| Key measurement | Volume of buyers and sellers, and the ability to maintain asset value during transactions | Liquidity ratios such as the current ratio, quick ratio, and cash ratio |
| Relevance to merchants | Important for selling inventory or investments at a stable price in the market | Crucial for managing daily operations, such as paying bills and handling refunds |
| Risk factor | Dependent on market conditions, which can fluctuate based on demand, supply, or external events | Dependent on the business's management of cash flow, receivables, and short-term debt |
| Objective | Maximizing the value of assets in the market | Ensuring the business can operate smoothly without disruptions caused by financial constraints |
Different Types of Asset Categories
The ease of converting assets into cash varies significantly, with some being highly liquid and others requiring more time and effort to sell. Here’s a breakdown of assets by their liquidity levels:
- Most liquid assets – cash, certificates of deposit (CDs), bank accounts, US treasuries,
- Semi-liquid assets – stocks and exchange-traded funds (ETFs), mutual funds, bonds, foreign currencies,
- Least liquid assets – real estate, art and antiques, jewelry, precious metals.
Knowing how quickly and efficiently each type of asset can be turned into cash is crucial for businesses to meet financial obligations or seize new opportunities.
Liquidity in Merchant Processing
As for merchants, liquidity is essential as it enables them to meet their daily financial obligations, such as paying for inventory, employee salaries, and operational costs. A merchant with adequate liquidity can maintain smooth business operations without resorting to high-interest loans or delays. Without it, businesses can struggle to pay suppliers, cover operating expenses, or manage unforeseen costs, and can be flagged as high-risk.
The Role of Liquidity in Managing Transactions
Liquidity also plays a crucial role in handling credit card transactions and also managing chargebacks and refunds. When customers dispute a transaction, merchants need to have enough liquid assets to process chargebacks promptly.
Similarly, the ability to quickly refund customers ensures a positive experience and minimizes potential issues with their merchant processing company. Insufficient liquidity can lead to delays in these processes and negatively impact a merchant’s reputation and relationships with both customers and credit card processing companies.
Measuring Liquidity – Key Ratios
To effectively assess liquidity, businesses use various financial ratios that provide insights into their ability to meet short-term obligations. Here are the most common liquidity ratios:
Current Ratio
The current ratio is calculated by dividing a company’s current assets by its current liabilities. It measures the ability of a business to cover its short-term obligations with its short-term assets.
Formula:
Current Ratio = Current Assets ÷ Current Liabilities
Interpretation:
A current ratio above 1 indicates that a business has more assets than liabilities, which suggests adequate liquidity. However, an excessively high ratio could indicate inefficiency in using assets.
Quick Ratio (Acid-Test)
Since inventory is not included in current assets, the quick ratio is a more cautious indicator of liquidity than the current ratio. This ratio focuses on a company’s ability to pay its short-term obligations without relying on inventory sales.
Formula:
Quick Ratio = (Current Assets − Inventory) ÷ Current Liabilities
Interpretation:
A quick ratio of 1 or above is considered good, indicating the company can pay off its current liabilities with its most liquid assets.
Cash Ratio
The cash ratio is the strictest measure of liquidity. It focuses solely on the company’s cash and cash equivalents to assess its ability to cover short-term liabilities.
Formula:
Cash Ratio = Cash and Cash Equivalents ÷ Current Liabilities
Interpretation:
A cash ratio of 1 means the company has enough cash to pay off all its current liabilities. A ratio lower than 1 may indicate a potential problem.
How Merchants Can Use These Ratios to Assess Their Financial Health
Merchants can use these ratios to evaluate their ability to meet short-term financial needs without having to rely on credit. They can make sure they have sufficient assets to cover operating expenses, deal with unexpected costs, and avoid cash flow problems if they routinely review these ratios. A good balance helps a business maintain healthy liquidity and keep financial stability.
Liquidity Challenges for Merchants
Merchants in the retail and service industries often face unique challenges due to the nature of their businesses. One of the main challenges is seasonal fluctuations. Retailers, for example, may experience slow sales during off-seasons, which creates gaps in cash flow. During these times, they might struggle to cover regular expenses and operational costs.
Another issue is high inventory costs. Retailers typically invest a large portion of their capital in inventory, and when sales slow down, it can strain their liquidity. This means they may have money tied up in unsold goods instead of having cash available for day-to-day expenses.
In service-based businesses, delayed payments can also cause cash flow problems. Service providers may have to wait weeks or even months before receiving payments for completed work. This delay makes it harder to maintain consistent cash flow, and it can potentially affect their ability to pay bills and meet other obligations.
Impact of Delayed Payments
Merchants often face several financial challenges that can significantly affect their liquidity and overall cash flow. While most businesses rely on consistent and timely payments from customers to maintain smooth operations, various factors can disrupt this process:
- Delayed payments – When customers or clients take longer to pay invoices or settle bills, businesses may struggle to cover their own costs. This can be particularly problematic for merchants relying on a continuous cash flow to meet day-to-day obligations.
- High processing fees – Payment processors often charge high fees for credit card transactions, which can reduce the funds available to businesses, especially smaller merchants with lower margins.
- Return item chargebacks – A chargeback occurs when a customer disputes a transaction, and it results in a refund being issued to the customer, often with additional fees. Frequent chargebacks can drain a merchant’s available cash and hurt their cash flow, particularly if they occur unexpectedly.
Strategies Merchants Can Apply to Manage Their Liquidity
Managing liquidity is one of the most critical aspects of running a successful business. For merchants, it’s not just about making sales but about ensuring there is enough cash flow to cover daily operational costs, such as paying employees or purchasing inventory.
According to a study by QuickBooks, 61% of small businesses experience cash flow problems, with 64% of those businesses facing issues related to delayed payments. The good news is that merchants can adopt several strategies to overcome these challenges:
- Encouraging quicker payments from customers, offering discounts for early payment, or switching to more predictable billing cycles can help stabilize cash flow.
- Extending payment terms with suppliers or negotiating better pricing can improve liquidity by reducing short-term outflows.
- Offering customers multiple payment options, such as digital wallets (like Google Pay, Apple Pay, and more) or ACH transfers, can reduce processing fees and improve cash flow.
- Establishing an emergency fund or cash reserve can help during slow sales periods or when unexpected costs arise.
- Merchants can lessen the possibility of chargebacks by proactively resolving consumer complaints and making sure that transaction terms are transparent.
How to Improve Liquidity as a Merchant
There are several ways to handle liquidity. You should regularly track cash inflows and outflows, automate invoicing, and set clear payment terms to speed up payments from customers. Using financial tools like merchant cash advances or business credit lines is another option.
Negotiating better payment terms with suppliers is also crucial. Merchants can also hold onto cash longer if they manage to extend payment deadlines or secure early payment discounts. Lastly, choosing reliable payment processors can make a big difference. Selecting processors with low fees and quick transaction times ensures that funds are available faster.
The Role of Merchant Processing Companies
Merchant services and credit card processing companies play a crucial role in helping businesses manage liquidity. They offer processing services that make payment processing quicker and easier, allowing merchants to receive funds quickly and securely.
Invest in Reliable Credit Card Processing Services
Choosing the right merchant processor is essential for maintaining good liquidity. Processors with lower fees ensure that more of the revenue stays with the merchant, while quicker payout options reduce waiting times for accessing funds. By selecting a credit card processing company that aligns with a business’s cash flow needs, such as Merchant Chimp, merchants can ensure smoother and more consistent liquidity. Contact us and get us started on your processing flow.
