A firm’s liquidity is its ability to pay its short-term liabilities on time and to turn assets into cash without undue losses. The basic question “what is liquidity” has a simple answer, but managing it requires the interplay of finance, business and law.
Liquidity measures how quickly and without significant loss of value a company can turn its assets (cash, receivables, inventory, securities) into cash and pay short-term liabilities – typically within 12 months. In practical terms, it looks like whether the company has enough money to pay wages, rent, advances to suppliers and loan repayments today and in the next few weeks.
Solvency is often confused with the concept of liquidity. But solvency is broader than that. It is the long-term ability to cover total liabilities with assets (the balance sheet). A firm may be solvent on the books (having assets in excess of debts) but illiquid in the short term because money is “stuck” in inventory or slow to collect invoices. Conversely, a firm with average assets may be highly liquid if it has a good cash reserve and collects quickly.
So what is the meaning of liquidity? In business, it determines whether a firm can handle unexpected fluctuations (customer failure, machine breakdown, seasonality). In a legal context, low liquidity can escalate into insolvency and trigger a chain of risks – defaults, contractual penalties, foreclosures, even insolvency proceedings. Therefore, liquidity is one of the pillars of financial health, along with profitability, leverage and efficiency.
We will conduct a quick audit of your business terms and collection processes. We will suggest specific modifications (T&C, penalties, collateral, retention of title, notarial deeds) and help you negotiate with key partners and the bank.
You can think of liquidity as the fuel for running a business. It’s not visible at first glance, but without it, business soon grinds to a halt.
In practice, it affects:
Beware, however, of the profitability paradox: Even a profitable firm can fail for lack of cash. All that is needed is for profits to remain “paper” (e.g., in inventory that cannot be sold or in receivables with long maturities). That is why it is essential to monitor cash flow and liquidity ratios alongside the income statement – only the confluence of healthy margins and good liquidity gives a business a solid foundation.
In practice, three “layers” of liquidity are distinguished according to how quickly assets can be turned into cash. Immediate (cash) liquidity means “how much money we have now”. It includes cash, account balances and very short-term securities. It is used for payments that cannot be deferred (wages, utilities, rent).
Prompt (quick) liquidity includes cash + short-term receivables (invoices that are realistically coming in soon). It excludes inventories because selling them requires time, marketing or discounts.
Ordinary (total) liquidity offers the broadest view. It includes total current assets (cash, accounts receivable, inventories, short-term financial investments) against current liabilities. It helps to estimate whether the firm could pay its liabilities in the normal course of business.
It is practical for the management of the firm to monitor all three. Immediate liquidity tells you whether you can pay the essentials “tonight”. Prompt liquidity will show you how the next few weeks will play out after invoices are collected. Current liquidity gives you a broader picture of the current asset structure – it will show if the business has “frozen” inventory or excessive capital tied up in work in progress. Each type has its limits: for example, high inventories may visually improve current liquidity, but they tend to be painful to monetize (discounts, logistics, service risks).
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Asset liquidity measures how quickly and at what price discount individual assets can be turned into cash. Cash is among the most liquid assets, followed by government or short-term securities. Slightly less monetizable are receivables, whose value depends on the reliability of the debtors. Inventories tend to be even less liquid, as their sale is affected by demand and seasonality. At the bottom of the list are machinery and equipment, real estate and the very slowest to sell are usually specific assets such as patents or prototypes.
An available attorney advises: If you are considering a major sale of company assets, it is advisable to legally handle everything so that you are not surprised by hidden risks later on. You need to look at warrantiesand liability for defects, the correct transfer of ownership and whether the transaction needs to be approved by the company authorities. It is also important to check that the property is not encumbered by a mortgage or loan conditions. In the case of operating assets, it is often more advantageous to obtain a short-term loan or advance against collateral than to resort to a quick sale at an unfavourable price.
Liquidity risk is the likelihood that a firm will be unable to pay its short-term liabilities on time. It arises both internally (poor cash flow management, poor inventory policy, benevolent due dates to customers, slow invoicing) and externally (sudden drop in demand, price increase of inputs, exchange rate fluctuations, delay of a key customer).
It is recommended to regularly monitor warning signs that may indicate deteriorating liquidity. These include, for example, an increasing proportion of overdue receivables and a generally worse age structure of debtors. It is also a good idea to note whether inventory is being sold more slowly and whether so-called deadweight items are accumulating, which only weigh on capital. Also pay attention to whether payments are being delayed more often and whether there are reminders or penalties. And if your bank signals a breach of credit terms, or suppliers start shortening payments or demanding advances, that’s a clear incentive for immediate action.
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If your company’s financial situation deteriorates significantly, it is important to keep in mind not only the money but also the legal liability of the management. The members of the statutory bodies need to monitor the company, take sensible action in a timely manner and protect creditors. If bankruptcy is already imminent, action must be taken without delay – waiting unnecessarily can lead to personal liability or even disqualification from office.
It is therefore advisable to keep clear documentation that you are addressing the situation, for example through liquidity summaries and minutes of meetings. In times of crisis, avoid transactions that may appear to favour certain creditors. Above all, do not delay in seeking professional help. Timely payment arrangements, agreements with partners or appropriate legal security can stabilise the business while reducing your personal risk.
A company’s liquidity means the ability to pay short-term obligations on time and to turn assets into cash, which is a fundamental prerequisite for the financial health of a business. It should be distinguished from solvency, which reflects the long-term coverage of all liabilities by assets. Adequate liquidity ensures stable operations, a better bargaining position and resilience to crises, while long-term deterioration can lead to sanctions, loss of partners or even bankruptcy. In practice, three levels are monitored – immediate, prompt and current liquidity – while it is important to pay attention to the liquidity of individual assets, from cash to receivables to real estate. The risk of illiquidity arises from both internal errors in cash flow management and external shocks, and is recognised by rising overdue receivables, slower inventories or frequent reminders. Liquidity management requires a combination of financial and legal tools: from fast invoicing, consistent collections and accounts receivable work, to factoring, credit frameworks or dead stock reduction, to strong contractual terms, collateral and notarization. In addition, company management has a legal responsibility to act in a timely manner when bankruptcy threatens, or risk personal sanctions.
The ability of the firm to pay short-term liabilities on time, i.e. to have sufficient cash available quickly.
None by itself. Follow the triple play: normal, prompt and instant liquidity, plus on trend and industry-specific.
Update forecasts immediately, accelerate invoicing and collections, negotiate bridge financing, reduce inventory and set up legal security on new contracts.
Liquidity = short-term solvency. Solvency = long-term coverage of liabilities by total assets.
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Ondřej is the attorney who came up with the idea of providing legal services online. He's been earning his living through legal services for more than 10 years. He especially likes to help clients who may have given up hope in solving their legal issues at work, for example with real estate transfers or copyright licenses.
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