How to Measure Liquidity - dummies

By Stephen L. Nelson

For many smaller businesses, liquidity is important. If you’re working with QuickBooks 2012 in a small-business setting, you need to understand the importance of liquidity. You have only a limited number of investments that you can make. Additionally, you have a limited amount of capital — less than you like, almost always.

New opportunities and ways to invest your money continually arrive. For these reasons, you typically want to look at the liquidity of your capital investments.

In large businesses, people don’t worry or talk as much about liquidity — at least when it comes to capital investments. Liquidity as a criterion for looking at capital investments is downplayed. The logic behind this is that, in most cases, very large firms have almost unlimited access to capital through the capital markets (either the stock markets, the debt markets, or even just big-time borrowing from enormous banks).

One easy way to measure liquidity is with a payback period, which measures what it takes for an investment to pay back its original investment. The office building example doesn’t work very well for this sort of calculation, so to make things a little easier, suppose that you are considering a $10,000 investment that produces $2,000 a year in net cash flows.

In this case, you can calculate the payback period with the following formula:

Payback period = initial investment/annual cash flow

In the case of the $10,000 investment described here, the actual formula is

$10,000/$2,000 = 5

This means that the $10,000 investment, through its $2,000 per year cash flows, takes five years to pay back.

Again, you don’t want to focus on liquidity. Liquidity is almost never as important as profitability. But even though profitability is paramount, liquidity is often something that you want to consider. At times, you’re going to want investments that pay back more quickly rather than those that pay back less quickly. When the investments do pay off, you’ll have other good reinvestment opportunities.