Liquidity

What is liquidity?

Liquidity denotes a company's ability to meet its due payment obligations at all times, on time and in full. Synonymous is solvency (German Zahlungsfähigkeit). In a wider sense, the term also means the available means of payment themselves as well as the property of an asset of being convertible into money quickly and without significant loss of value.

The term has a business and a legal side. In business terms, liquidity is measured with metrics from the balance sheet and with forward-looking planning; in legal terms, the German Insolvency Code (Insolvenzordnung, InsO) links to the ability to pay debts. A company can be worth a great deal and still be unable to pay a due invoice if its assets are tied up in machines, software or customer receivables. In funding rounds, the stock of liquid funds determines the company's runway; in company acquisitions, it enters the purchase price calculation.

Liquidity as a stock and as a period figure

At the reporting date, the balance sheet shows liquid funds under the item cash in hand, balances at the Bundesbank, balances at credit institutions and cheques (Section 266(2) of the German Commercial Code, HGB). Whether the company can pay in the following weeks is not shown by this figure, because it contains neither the upcoming due dates nor the expected receipts.

Practice therefore distinguishes two views. The static view sets the available funds against the due liabilities at a reporting date; in insolvency law this statement is called a financial status (Finanzstatus). The dynamic view projects receipts and payments forward and is the subject of liquidity planning. The ongoing management of stock, planning, credit lines and the investment of surplus funds is called liquidity management. For the test of solvency, committed credit lines that have not been drawn count among the available funds, insofar as they can actually be drawn. In the calculation of runway, by contrast, they are usually shown separately, because the bank can terminate or cut them.

Liquidity ratios: formulas for the 1st, 2nd and 3rd degree

Liquidity ratios set parts of current assets, that is, of the assets that are meant to turn into cash in the short term, in relation to short-term liabilities. Short-term liabilities are those with a remaining term of up to one year; their amount must be noted for each liability item under Section 268(5) HGB. The formulas are:

• Liquidity of the 1st degree (cash ratio) = liquid funds / short-term liabilities × 100%
• Liquidity of the 2nd degree (collection-based liquidity, quick ratio) = (liquid funds + short-term receivables) / short-term liabilities × 100%
• Liquidity of the 3rd degree (sales-based liquidity, current ratio) = (liquid funds + short-term receivables + inventories) / short-term liabilities × 100%

Frequently cited benchmarks are at least 100% for the second and 150 to 200% for the third degree. Such rules of thumb are only a rough indication: the ratios relate to a reporting date that is often months in the past and reflect neither due dates nor the quality of receivables and inventories. The absolute counterpart of the third degree is working capital.

Liquidity, profitability and equity

Liquidity and profitability

Profitability measures success in relation to the capital employed or to revenue. Under the HGB realisation principle, profit arises as soon as the service has been rendered, regardless of when the customer pays. Liquidity arises only on receipt of payment.

A growing company with long payment terms therefore reports profits and nevertheless has too little money in its account. A software provider that invoices annual contracts in advance, by contrast, can be liquid even though it makes losses. At the same time the two goals are in tension, because a reserve in the account earns hardly any return. Finance theory summarises this conflict of objectives in the triangle of liquidity, profitability and security.

Liquidity and equity

Equity stands on the liabilities side of the balance sheet and shows the extent to which assets are financed with shareholders' funds, but not the form in which these assets exist. A high equity ratio does not protect against payment difficulties if the assets are tied up in fixed assets or receivables. Conversely, a company whose equity is used up can be liquid, for example because shareholders have granted loans.

If equity has been used up by losses, the balance sheet shows a deficit not covered by equity (Section 268(3) HGB). This balance sheet over-indebtedness is not the same as over-indebtedness in the sense of insolvency law but gives cause to examine it.

Liquidity in insolvency law

The Insolvency Code knows three grounds for opening proceedings that link directly or indirectly to solvency. Illiquidity (Zahlungsunfähigkeit, Section 17 InsO) exists if the debtor is unable to meet due payment obligations. It is generally to be assumed if the debtor has stopped payments. Case law distinguishes it from a mere payment bottleneck. If a gap can be closed within three weeks, there is regularly only a bottleneck. If the gap remaining after that is 10% or more of the due liabilities, illiquidity is regularly to be assumed. This does not apply if it will, with a probability bordering on certainty, soon be almost completely closed and creditors can reasonably be expected to wait. A smaller gap generally speaks against illiquidity, as long as it is not foreseeable that it will grow.

Imminent illiquidity (Section 18 InsO) exists if the debtor will presumably be unable to meet existing payment obligations when they fall due. As a rule a forecast period of 24 months is to be applied. It entitles the company to file for itself but does not oblige it, and opens access to the restructuring instruments of the German Act on the Stabilisation and Restructuring Framework for Businesses (Unternehmensstabilisierungs- und -restrukturierungsgesetz, StaRUG). Over-indebtedness (Überschuldung, Section 19 InsO) requires that assets no longer cover existing liabilities and that there is no positive going-concern forecast for the next twelve months. The forecast answers above all whether the company remains able to pay its debts in this period.

For the GmbH (German limited liability company), the management's duty to file arises from illiquidity and over-indebtedness under Section 15a InsO. The petition must be filed without culpable delay, at the latest three weeks after the onset of illiquidity and six weeks after the onset of over-indebtedness. After the onset of insolvency in the legal sense (Insolvenzreife), that is, from illiquidity or over-indebtedness, payments are in principle prohibited; payments made in breach of the prohibition must be reimbursed to the company by management (Section 15b InsO). Whether a ground for opening exists depends on due dates and financing prospects in the individual case. To prevent it coming to that, Section 1 StaRUG obliges management to carry out ongoing early crisis detection.

Liquidity in funding rounds and company acquisitions

In a funding round, investors ask about the stock of liquid funds, the monthly cash outflow and the resulting runway. In financial due diligence, the review of the financial figures by investors or buyers, the reviewers reconcile bank balances with bank statements or bank confirmations. They watch for restrictions on disposal, such as pledged balances or earmarked grants.

In a company acquisition, the purchase price is usually agreed on a debt-free and cash-free basis (cash-free/debt-free). Freely available liquid funds increase the equity value, the price for the shares, and financial liabilities reduce it. For the period between signing and closing, contracts generally prohibit cash outflows outside the ordinary course of business.

Worked example: calculating liquidity ratios and checking due dates

The balance sheet of a trading company at 31 December shows liquid funds of EUR 400,000, short-term trade receivables of EUR 900,000 and inventories of EUR 700,000. Short-term liabilities are EUR 1,250,000: EUR 600,000 to suppliers, EUR 150,000 to the tax office and EUR 500,000 to the bank.

• Liquidity of the 1st degree: 400,000 / 1,250,000 = 32%
• Liquidity of the 2nd degree: (400,000 + 900,000) / 1,250,000 = 1,300,000 / 1,250,000 = 104%
• Liquidity of the 3rd degree: (400,000 + 900,000 + 700,000) / 1,250,000 = 2,000,000 / 1,250,000 = 160%
• Working capital: 2,000,000 minus 1,250,000 = EUR 750,000

By the rules of thumb, the position looks sound. The due dates in January give a different picture: on 10 January, wage tax and VAT for December of EUR 150,000; during the month, supplier invoices of EUR 330,000; and at month end, salaries with social security contributions of EUR 220,000. Two major customers with receivables of EUR 550,000 in total will pay only in February; by the end of January only EUR 250,000 comes in.

• Available by the end of January: 400,000 + 250,000 = EUR 650,000
• Due by the end of January: 150,000 + 330,000 + 220,000 = EUR 700,000
• Gap: 700,000 minus 650,000 = EUR 50,000

The reporting-date ratios do not show this gap because they do not reflect due dates. It can be closed, for example, through a callable credit line or an advance payment by a major customer against a cash discount, provided it is recognised before the due date.

Distinctions: liquidity, liquidity planning, cash flow and creditworthiness

• Liquidity planning: the instrument with which future solvency is projected. Liquidity is the state that the planning is meant to secure.
• Cash flow positive: describes a period in which receipts exceed payments. A company with negative cash flow remains liquid as long as the stock covers the outflows.
• Creditworthiness: credit standing from a lender's point of view. Liquidity is an important but not the only component of this assessment.

Common mistakes

• Account balance equated with liquidity. The bank balance contains amounts to which the company is not economically entitled, such as VAT collected and wage tax withheld, which flow to the tax office at the next due date.
• Profit as proof of solvency. A positive result says nothing about whether receipts arrive in time before due dates.
• Payment bottleneck played down. Anyone who treats a gap lasting weeks as temporary without being able to close it demonstrably risks missing the deadlines of Section 15a InsO.
• Funds with a single bank. After a funding round the proceeds often lie entirely in one account, although statutory deposit protection is limited to EUR 100,000 per depositor and bank.

Frequently asked questions

Can a company with a profit become unable to pay its debts?

Yes. If a company grows quickly and grants long payment terms, money flows out for staff, materials and taxes before customers pay. The result is then positive, but the funds are not sufficient.

How is liquidity calculated?

In two ways. As a ratio, the liquid funds, for the 2nd and 3rd degree plus receivables and inventories, are divided by the short-term liabilities. Whether the company can actually pay is shown only by a financial status: available funds and callable credit lines against the payments falling due in the next weeks.

Which liquidity ratio is most meaningful?

For a short-term assessment, as a rule the second degree, because it leaves out inventories, whose realisation takes time.

Do shareholder loans count towards liquidity?

The funds paid out increase liquid funds, but the repayment claim is a liability. In insolvency it ranks behind other claims (Section 39(1) No. 5 InsO), and with a qualified subordination agreement it is also not recognised in the over-indebtedness test. Such subordinated liabilities strengthen liquidity without burdening the over-indebtedness calculation.

How high should the liquidity reserve be?

That depends on the business model and on the fluctuation of cash flows. As a rule of thumb, the reserve (minimum liquidity) covers at least the fixed payments of one month, that is, salaries with contributions, rent and the next tax due dates. Companies that are still making losses also plan the runway until the next financing.

The Roemer Capital view

In sale mandates, Roemer Capital clarifies early which liquid funds count as freely available and thus increase the purchase price. Rent deposits, balances with restrictions on disposal, customer prepayments received and a minimum operating cash balance are regularly subject to negotiation. Every euro that falls out of the definition is missing from the sellers' equity value.

As fractional CFO, Roemer Capital keeps a liquidity status for clients that shows, besides the account balance, the payments due in the next weeks. If a gap emerges that cannot be closed from the company's own resources, that is the moment to involve the company's law firm. The assessment under insolvency law lies there; Roemer Capital supplies the figures for it.