Liquidity Explained Simply

As part of the financial world, liquidity is also important for companies’ day-to-day operations. Good financial liquidity helps businesses meet their ongoing obligations and remain solvent. In this article, you’ll learn what liquidity means, which liquidity ratios exist, and why liquidity planning is important for companies.

What it is: Liquidity is a company’s ability to meet short-term payment obligations on time using available liquid assets.
Which liquidity ratios exist: First-degree, second-degree, and third-degree liquidity show how well companies can cover their short-term liabilities with available assets.
Why liquidity is important: Good financial liquidity helps companies pay ongoing costs, make investments, and remain economically flexible.
What happens when there is a liquidity shortage: If there are not enough liquid assets, payment delays, additional financing costs, or, in the worst case, insolvency may occur.

Definition: What Is Liquidity?

Liquidity describes the ability of a person or company to meet outstanding payment obligations on time. Financial liquidity therefore shows whether enough liquid assets are available to pay ongoing costs such as invoices, salaries, or loans.

Put simply, liquidity means having enough money available to remain solvent. Good liquidity enables companies to maintain daily business operations and meet short-term obligations.

What Is the Difference Between Liquidity and Profit?

Liquidity and profit are often confused, but they describe different financial metrics. While a company’s liquidity shows whether short-term payment obligations can be met, profit describes the financial surplus after all expenses have been deducted.

A company can generate a profit and still have liquidity problems. This can happen, for example, when customers pay invoices late and too few liquid assets are available in the short term.

That is why both metrics are important for companies:

Good liquidity helps pay ongoing costs on time.
Long-term profit shows whether a company is operating profitably.
A lack of liquidity can lead to financial difficulties despite profitability.

Liquidity Planning: Which Liquidity Ratios Exist?

Liquidity planning helps companies keep track of their solvency and meet ongoing payment obligations on time. It is based on various key figures that compare available funds with short-term liabilities.

The most important key figures include first-degree liquidity, second-degree liquidity, and third-degree liquidity. They show how well a company can cover short-term obligations with existing liquid assets and other assets.

Below, you’ll learn how the individual liquidity ratios differ and what they indicate about a company’s financial liquidity.

First-degree liquidity describes whether a company can immediately settle its short-term liabilities using available cash and cash equivalents. It is also known as the cash ratio and is considered an important metric for assessing short-term solvency.
First-degree liquidity includes, among other things:
Cash and cash holdings
Bank balances
Immediately available liquid assets
This metric shows how well a company can respond to unexpected expenses or short-term payment obligations. A high first-degree liquidity ratio can help avoid short-term financial bottlenecks.
Second-degree liquidity shows whether a company can cover its short-term liabilities with assets that are available in the short term. Unlike first-degree liquidity, it also takes outstanding receivables and other short-term cash resources into account.
Second-degree liquidity includes, among other things:
Outstanding receivables from customers
Checks
Bills of exchange
Short-term marketable securities
This metric provides a more realistic picture of financial liquidity because it includes expected incoming payments as well as immediately available funds. This makes it easier to assess whether a company can meet its short-term obligations in the near future.
Third-degree liquidity takes a company’s entire current assets into account to assess its short-term solvency. Compared with the previous liquidity ratios, it also includes inventories and other assets that are less quickly converted into cash.
Third-degree liquidity includes, among other things:
Inventories and stock
Raw materials, supplies, and operating materials
Short-term receivables
Liquid assets and bank balances
This metric provides a broader overview of a company’s financial liquidity because it considers almost all current assets. This makes it easier to assess whether companies can meet their financial obligations even when some assets are tied up for longer periods.

How Is a Company’s Liquidity Measured?

A company’s liquidity is measured using various key figures. The liquidity ratios are especially important because they show how well short-term liabilities can be covered by existing assets.

Liquidity is often calculated using the following formulas:

First-degree liquidity: liquid assets ÷ short-term liabilities
Second-degree liquidity: (liquid assets + short-term receivables) ÷ short-term liabilities
Third-degree liquidity: current assets ÷ short-term liabilities

The result is usually given as a percentage. A value of 100% or more means that, mathematically, a company can fully cover its short-term liabilities with existing assets.

In addition to liquidity ratios, companies use other key figures to assess their financial liquidity:

Cash Ratio

Measures whether a company can settle its short-term liabilities using only immediately available cash resources. This metric therefore focuses on especially liquid assets such as cash or bank balances.

Operating Cash Flow

Shows how much liquid cash a company generates through its ongoing business activities. Positive operating cash flow can indicate that ongoing costs, liabilities, and investments can be paid for from operating activities.

Why Is Liquidity Important for Companies?

A company’s liquidity affects whether ongoing costs can be paid, investments can be made, and financial obligations can be met. Even profitable companies can run into difficulties if they do not have enough liquid assets available in the short term.

Sufficient liquidity is important for companies for several reasons:

Invoices, salaries, and ongoing costs can be paid on time.
Short-term liquidity shortages can be managed more effectively.
Companies can respond more quickly to unexpected expenses.
Investments and growth plans can be implemented more easily.
Companies remain financially more flexible and can respond to changes faster.
Banks and business partners often view companies with good liquidity more positively.

Liquidity can also be important for you as an investor. Companies with financial problems often have to postpone investments or take on additional financing. In the long term, this can affect a company’s economic development and therefore its value.

What Happens When There Is a Lack of Liquidity?

A liquidity shortage occurs when a company does not have enough liquid assets or assets available in the short term to pay outstanding liabilities on time. This can restrict a company’s solvency. Common causes of liquidity bottlenecks include late incoming payments, unexpected expenses, or inadequate liquidity planning.

The most common consequences of a liquidity shortage are:

Late payments: Invoices, salaries, or ongoing costs cannot be paid on time.
Additional costs: Reminder fees or default interest increase the financial burden.
Lower creditworthiness: Low liquidity can worsen a company’s credit rating.
Financing needs: Companies may have to take out short-term loans or obtain additional financing.
Loss of trust: Banks, suppliers, and business partners may lose confidence in the company.
Insolvency: In the worst case, a persistent lack of liquidity can lead to insolvency.

Conclusion: Liquidity Planning Is Very Important for Companies

Available liquidity affects how flexibly companies can respond to changes, unexpected costs, or economically difficult periods. Companies that plan income, expenses, and available funds early can better assess financial risks and make necessary decisions more quickly.

The different liquidity ratios help provide a realistic assessment of a company’s financial situation. This can be relevant not only for companies themselves, but also for you as an investor when evaluating a company’s economic development.

Liquidity also plays an important role in financial markets and cryptocurrencies, as it often affects how quickly assets can be bought, sold, or converted into other funds.

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Frequently Asked Questions About Liquidity

Here you’ll find answers and explanations to the most frequently asked questions about liquidity.

Companies can improve their liquidity by making income available more quickly and controlling expenses more effectively. Measures may include:
Receivables management: Outstanding receivables are monitored and followed up on at an early stage.
Credit lines: Short-term financing can help bridge financial bottlenecks.
Sale of assets: Assets that are no longer needed can create additional liquid funds.
Liquidity planning: Income, expenses, and potential risks are reviewed regularly to identify liquidity shortages early.
Liquidity describes how many liquid assets a company currently has available to pay ongoing costs and short-term payment obligations. Cash flow, on the other hand, shows how much money flows into and out of a company within a specific period.
While liquidity describes the current financial room for maneuver, cash flow shows how a company’s income and expenses are developing. Both metrics help provide a better assessment of a company’s financial situation.