Cash vs Liquidity: What is the difference between the two?
The early stage of your entrepreneurship journey may have been about raking in the maximum annual revenue to defray the costs of your startup. But as you enter the growth stage, it’s essential to have an understanding of some financial terms that float around in the world of business. Two of the most important of them are "cash" and "liquidity."
The difference between "cash" and "liquidity"
There is often confusion between the terms, "cash" and "liquidity," as they are often used interchangeably. However, they are not the same thing. Cash refers to physical currency, such as paper money or coins, that is readily available for use in transactions. This is often the cash held in bank accounts.
Liquidity, on the other hand, refers to the ability of an asset or financial instrument to be quickly converted into cash without influencing its market price. Cash is the most liquid of assets, while tangible items are less liquid. The golden rule to remember here is cash is a component of liquidity but liquidity encompasses more than cash.
Meeting financial obligations as a startup founder
Take, for example, your startup generates a large amount of cash. However, investing and tying up your cash in investments or other assets that cannot be easily sold may not leave you with enough liquidity to meet your financial obligations.
On the other hand, your business may not have much cash in hand or a bank account. But if you have assets that can be easily sold, (stocks or bonds are great examples), you may still have sufficient liquidity to meet your debts.
If your business has cash, can it have negative liquidity? Absolutely. Let’s assume your business has $100k of cash and no other sources of liquidity but it has payables of $175,000 due in 7 days. It would have negative liquidity of $75,000. In that case, your startup will be cash-rich but liquidity poor.
So, who’s the king: cash or liquidity?
To answer this, you should know about liquidity risk. Liquidity risk is the risk that your business will be unable to meet its financial obligations when they come due. This can occur if your business does not have enough cash or liquid assets to pay its debts, such as accounts payable, wages, or loans when due.
Liquidity risk can be a concern for your startup, posing a hurdle on its growth path, as it can lead to financial distress and at worse, bankruptcy. To manage liquidity risk, you should measure and forecast your business’ liquidity and maintain a sufficient level of liquid assets.
Some examples of these assets include cash, short-term investments, and other assets that can be easily converted into cash. Moreover, you should also have a plan in place for managing your business’s cash flow, including taking measures such as borrowing or selling assets if necessary.
Final thoughts
So, the difference between cash and liquidity is simple. Cash refers to physical currency, while liquidity refers to the ability to quickly convert an asset or financial instrument into cash. Knowing the difference between the two terms and the proper management of liquidity risk is crucial for your startup to avoid financial distress and maintain financial stability as it progresses toward growth.