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How Debt Affects a Company’s Liquidity

Reading time: 3 minutes.

From this article, you will learn:

  • How to define liquidity,
  • The indicator of the company’s liquidity,
  • The precondition for raising external capital.

Junior Accountant at RSM Poland

The company’s debt ratio is an important criterion for assessing business performance. Even though raising external capital prompts faster growth and boosts your profitability, you must remember that this kind of capital raising involves significant risks. Liquidity hazards seem to be critical here.

Debt repayment and service do not hinge upon the company’s performance. If a company generates less cash inflows than it is necessary to cover its debts, it may have problems with liquidity. In extreme cases, it may even cause the company to go bust.

In order to avoid such drastic consequences of relying on external sources of financing, it is crucial to monitor the dependency of the company’s liquidity in relation to its debt. This requires appropriate economic analysis tools.

What is liquidity?

Most companies finance their operations through external sources of funding. Only few are able to operate only based on their own equity.

To obtain external capital, which mostly includes long-term loans, the company must first demonstrate its ability to borrow short-term. Doing this requires you to fully understand what liquidity is[1].

In literature, the concept of liquidity does not tend to be explained clearly and is sometimes confused with the concept of solvency. To avoid misunderstandings and errors, it is a good idea to rely on short and simple definitions. In a nutshell, liquidity can be defined as “the ability to pay current liabilities on time” [2].

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Structure of the liquidity model

The level of liquidity in a company is determined by many factors. In order to investigate them, the following asset structure is used, among others [3]:

Structure of the liquidity model

The presented relationship between current assets and current liabilities is a reflection of the current liquidity ratio. Its first part reflects the structure of assets, whereas the second the structure of the sources of financing. The ratio of total liabilities and current liabilities reveals the final debt structure [4].

According to the above model, basic factors affecting the company’s liquidity include:

  • assets,
  • sources of financing,
  • debt.

What should be noted here is that in the case of asset structure, liquidity is going to be higher if current assets have a greater share in the asset structure.

The structure of sources of financing may affect the liquidity, as well. The reason seems quite obvious: companies that are indebted find it more difficult to pay their current liabilities.

Fortunately, the next step is easier. Knowing the structure of short-term liabilities, you can determine the share of liabilities owed to related parties. The higher it is, the greater the chances that liquidity is going to improve[5].

Control over a company’s debt

When choosing external capital as the source of financing for your company, you must remember that the management of your short-term liabilities requires proper supervision. If you do not have time for this, it is better not to underestimate this task and hand it over to an accounting office providing outsourced payment management services.

Why is this so important? Financial liabilities under loan agreements include, among others, the repayment of principal instalments plus interest, the repayment of which covers the entire fiscal year. What this means that only with appropriate management of your short-term liabilities, supported by expertise in payment accounting, and keeping an appropriate level of profitability, can you maintain stable liquidity in your company[6].

Wrapping up, before you decide to finance your operations from external sources, it would be wise to perform an extensive analysis of your operations to date and check your accounting data, as it will allow for an accurate assessment of how the debt may affect your company’s liquidity. As the name suggests, handling liquidity is no trifle: if you lose it, the consequences may be serious.

[1] W. Gabrusewicz: Analiza finansowa przedsiębiorstwa. Teoria i zastosowanie. (Corporate financial analysis. Theory and practice), Polskie Wydawnictwo Ekonomiczne, Warsaw 2014, p. 341.
[2] M. Sierpińska, T Jachna: Ocena przedsiębiorstwa według standardów światowych. (Company assessment according to international standards), Wydawnictwo Naukowe PWN, Warsaw 2009, p. 145.
[3] M. Sierpińska, T Jachna: Ocena przedsiębiorstwa…,(Company assessment…), citation. p. 149.
[4] M. Sierpińska, T Jachna: Ocena przedsiębiorstwa…( Company assessment…), citation. p. 149 .
[5] Ibid., p. 152.
[6] B. Pomykalska, P. Pomykalski: Analiza finansowa przedsiębiorstwa. (Corporate financial analysis), Wydawnictwo Naukowe PWN, Warsaw 2007, p. 77.

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