How Does Your Liquidity Impact Your Ability to Secure Venture Debt?
In 2024, the value of US venture debt deals nearly doubled to $53.3 billion, more than 25% of the value of venture capital investments in the same period. This marks a significant increase from 2001 when venture debt was only 5% of the value of venture capital investments.
So, as more startups turn to venture debt to extend their runway, founders must understand the key factors in securing such financing. While venture debt lenders have a large risk appetite and have more weight on growth potential than traditional banks, they still investigate a startup’s financial health before offering venture debt. One of the key factors that venture debt lenders often consider is liquidity management.
This article explains what liquidity means for businesses, how investors perceive it, and how venture debt lenders assess the financial liquidity of a company. Read on to know more!
What is liquidity in business?
In a business context, liquidity is a company’s ability to meet its short-term liabilities. Some short-term liabilities include payroll expenses, accounts payable, business credit cards, bank overdrafts, and accrued expenses. For certain businesses, such as banks, liquidity is as important as solvency. After all, a bank may have to shut down if it fails in liquidity management and cannot handle deposit withdrawal requests.
To understand a business’s liquidity, we look at the difference between its short-term liabilities and cash reserves or all of its current assets. However, to get a more nuanced view of liquidity, you can use liquidity ratios such as the ones discussed below:
| Liquidity ratio | Formula | Interpretation |
|---|---|---|
| Current ratio | Current ratio=Current assets/Current liability | Proportion of current liabilities that can be addressed using current assets |
| Quick ratio | Quick assets=Current assets-Inventory-Prepaid expenses Quick ratio=Quick assets/Current liabilities | Proportion of current liabilities that can be addressed with cash or assets that are easily convertible into cash |
| Cash ratio | Cash ratio=Cash+Marketable securities/Current liabilities | Proportion of current liabilities that can be readily addressed |
| Defensive interval ratio (DIR) | Defensive interval ratio DIR=Current assets/Daily expenditures | Number of days a company can keep operating with its present level of current assets |
Why do we have so many liquidity ratios?
Each liquidity ratio helps us assess liquidity from a unique lens.
While the current ratio is the most used liquidity ratio, it can often be misleading as not all current assets are equally liquid, i.e., equally easy to convert into cash. Current assets examples include cash, accounts receivable, inventory, treasury bills, and prepaid expenses. Out of these assets, inventory cannot be immediately converted into cash, and prepaid expenses will only depreciate with time and cannot be converted into cash.
To address this concern, we measure liquidity using the quick ratio, where current assets sans the prepaid expenses and inventory are considered.
You may have noticed that a business has limited control over how quickly its accounts receivable are converted into cash. Hence, such current assets are not reliable for dealing with urgent liquidity needs. To address this concern, we measure liquidity using the cash ratio, which only considers cash and marketable assets.
Finally, we must understand how a business’s liquidity management impacts its operations. For this purpose, we use the defensive interval ratio (DIR).
How does liquidity impact creditworthiness?
A business’s liquidity management determines its ability to procure raw materials, hire and retain employees, and enter into credit contracts with vendors and customers. This has a huge impact on a business’s ability to generate revenue. From a lender’s perspective, a business can be a viable customer only if it consistently generates revenue.
Solvency is important to assess how much long-term debt can be extended to a business. However, the quality of liquidity management helps increase the stability of cash flows, smoothness of operations, and repayment capacity.
How does liquidity impact a company’s ability to attract investors?
The quality of a company’s liquidity management impacts its ability to raise funds in the following manner:
- Investor confidence – Unless an investor intends to acquire your company to dissolve it and absorb its key assets, they will be interested in your operational efficiency. When your company has quality liquidity management, operational stability is only one of the benefits. It will also have a greater ability to enter into new contracts with vendors, lenders, and customers, and enter new markets or launch new products.
- Attracting institutional investors – Institutional investors seek companies with efficient operations whose valuations can increase through optimizations. Effective liquidity management is essential for smooth operations. This will give them more confidence in your company’s growth potential. Healthy liquidity also provides greater flexibility in the kind of strategic optimizations that can be pursued and increases the margin for error.
- Lower cost of capital – When a company has sound liquidity management, it has low operational risks. Consequently, investors are less likely to demand a risk premium. In the context of startup fundraising, this would mean that lower discount rates will be applied in discounted cash flow (DCF) or other financial models. This directly increases the startup’s valuation.
- Enhanced market visibility – When your business operates smoothly, it will build a solid reputation with its business partners and customers. These positive insights will enhance your brand equity, helping you attract more customers and partnerships. As a result, your business will become a stand-out player in your industry, making it more likely to be shortlisted as an investment opportunity.
How do venture lenders evaluate a company’s liquidity?
A venture debt lender will assess a prospective borrower’s liquidity by studying its liquidity ratios, burn rate, runway, cash reserves, and other metrics. Let us understand this process through an example.
Here, we will analyze the liquidity of two venture-backed startups applying for venture debt. Their current assets and liabilities are below:
| Current assets | Cloud Fusion | Syncify | Current liabilities | Cloud Fusion | Syncify |
|---|---|---|---|---|---|
| Cash | $100,000 | $50,000 | Accounts payable | $80,000 | $60,000 |
| Treasury bills | $40,000 | $ - | Short-term debt (business credit cards) | $40,000 | $35,000 |
| Accounts receivable | $120,000 | $80,000 | Payroll expenses | $20,000 | $25,000 |
| Inventory | $80,000 | $30,000 | Bank overdraft | $15,000 | $ - |
| Prepaid expenses | $30,000 | $20,000 | |||
| Total | $370,000 | $180,000 | Total | $155,000 | $120,000 |
Assuming daily expenditures of $18,000 and $8,000 for Cloud Fusion and Syncify, respectively, let us calculate their liquidity ratios.
| Liquidity ratio | Cloud Fusion | Syncify |
|---|---|---|
| Current ratio | $370,000/$155,000 = 2.39 | $180,000/$120,000 = 1.50 |
| Quick ratio | $370,000-$80,000-$30,000/$155,000 = 1.68 | $180,000-$30,000-$20,000/$120,000 = 1.08 |
| Cash ratio | $100,000+$40,000/$155,000 = 0.90 | $50,000/$120,000 = 0.42 |
| Defensive interval ratio (DIR) | $370,000/$18,000 = 20.56 | $180,000/$8,000 = 22.50 |
By analyzing these liquidity metrics, we can see that Cloud Fusion is better positioned than Syncify. It has a better current ratio, quick ratio, and cash ratio. Syncify’s only edge would be in the defensive interval ratio (DIR), however, this edge is only marginal. Thus, Cloud Fusion is better positioned to scale operations without making any capital expenditures.
Thus, purely based on the quality of liquidity management, Cloud Fusion is more likely to receive venture debt funding.
Tips to improve liquidity
Some measures that can improve your liquidity management are as follows:
- Establish cash reserves – You can demarcate cash reserves to be accessed only in certain emergencies. To better manage these reserves, you can categorize potential emergencies by severity. Then, you should use the reserves only when an emergency of the designated severity level arises.
- Wise utilization of credit lines – You can use credit lines to cover short-term cash shortages without needing to sell assets. By using credit lines, your company can maintain smooth operations while ensuring that you have the necessary capital to meet unexpected expenses or opportunities.
- Extend payables – Liquidity management can be a lot simpler if your accounts payable have longer repayment terms. Even extending the average payment timeline by just a few days can significantly extend your financial runway over time.
Eqvista- Empowering growth with liquidity solutions!
Improving liquidity management can be an important measure to improve your chances of securing venture debt. It shows that you manage your cash reserves responsibly and are committed to building a commercially viable business. Another thing you could aim for is effective short-term debt management, which not only boosts liquidity but also showcases your ability to act in a fiscally responsible manner.
While venture debt is becoming increasingly mainstream, many founders are still unaware of the strategies to secure it. Eqvista has partnered with Cheqly to make venture debt more accessible for startups. To learn more about how we can assist you in securing venture debt, contact us now!
