Why maintaining liquidity is so important for small business owners
MARTIN A. SCOTT, CFP®, EA
For a small business owner, maintaining liquidity is usually not the most exciting thing to do, but it is still a core element of business operations and a successful financial plan. Liquidity is the ease with which a specific asset can be converted into cash, meaning that cash is the most liquid asset a small business owner can have on their balance sheet. On the other hand, an asset with low liquidity is one that could take more time to sell and result in a significant change in its value. Liquidity should be viewed by a small business owner as a strategic asset that provides flexibility to maintain operations, navigate through uncertain economic times, and capitalize on potential growth opportunities. In addition to these tangible benefits (three of them listed below) of maintaining liquidity, there is also an intangible benefit to a small business owner, which is having peace of mind knowing that their business can survive and potentially grow even through challenging times. As a result, this can reduce stress and lead to a healthier lifestyle.
Operations
To keep any business going, an owner must manage its day-to-day operations and having liquidity is the source to do so. Liquidity provides financial flexibility to cover recurring expenses such as payroll obligations, rent, and utilities. Additionally, if a small business owner currently has debt (e.g., maintaining a credit line to bolster growth), liquidity helps with the management of debt payments by providing the ability to address these financial obligations quickly. Most importantly, there will be unexpected circumstances (e.g., emergency expenses, fluctuations in revenue) that occur no matter how well a small business owner plans so liquidity can safeguard a business against these potential items.
Managing an economic downturn
In times of a recession and/or market uncertainty, small business owners are particularly impacted as they might face issues such as reduced consumer spending and higher costs of borrowing, which both can have a negative impact on profit and growth. Reduced consumer spending directly lowers revenue and higher costs of borrowing makes it more difficult for a small business owner to obtain additional financing, which ultimately can slow the growth of their business going forward. Maintaining liquidity gives a small business owner the capacity to get through these types of time periods by having adequate resources to still explore areas for growth and keep employees despite lower revenues.
Take for example how the Federal Reserve has been trying to battle inflation since 2022 by raising the Federal Funds Rate multiple times (resulting in this Federal Funds Rate increasing by more than five percentage points). These rate increases lead to higher costs of borrowing (e.g., higher interest rates on business loans) for small business owners. In this type of economic environment, a small business owner that has specific growth plans and maintains a strong liquidity position would not have to completely rely on getting financing at higher interest rates. Instead, they could use liquidity to accomplish their stated goals during this uncertain time.
Taking advantage of opportunities
“Strong liquidity can potentially lead to obtaining favorable terms (due to having immediate access to cash) in transactions with suppliers and lenders, which can result in cost savings for a small business owner.”
There will be times when an opportunity arises for a small business owner that can significantly bolster the growth of their business. Some examples could include adding a new service, investing in new technology, hiring an employee or consultant, and gaining a credential to increase knowledge/establish more credibility with potential clients. These types of opportunities can sometimes come up quickly so having liquidity allows a small business owner to move forward immediately since there will not be any financial limitations. Maintaining this level of financial stability also allows for flexibility and confidence when planning for strategic initiatives (e.g., 1-year business plan, 5-year business plan). Even further, strong liquidity can potentially lead to obtaining favorable terms (due to having immediate access to cash) in transactions with suppliers and lenders, which can result in cost savings for a small business owner.
Take for example this situation where a small business owner has decided to focus on establishing a niche. Peter owns a business consultancy firm and has successfully run it for five years but has realized that he must start focusing on establishing a niche to grow efficiently and be more profitable. He decides that his niche will be real estate companies and focusing on consulting for this niche is the best way for him to move forward. Peter understands that focusing on this niche will require a major investment in his marketing efforts (hiring a marketing consultant and creating marketing content), new technology (purchasing a specific software that will provide solutions to his niche) and gaining more specific knowledge about these types of real estate companies (joining industry organizations and obtaining a credential that is well known by his niche). Since he maintains a strong liquidity position, Peter can capitalize on these opportunities swiftly, which will get him on track for his stated goals for growth.