How can businesses assess the impact of an investment on liquidity?

Businesses can assess the investment impact on liquidity by analysing cash flow forecasts, liquidity ratios, and working capital.

To understand the impact of an investment on liquidity, businesses need to consider several factors. Firstly, they can use cash flow forecasts. This involves predicting the inflow and outflow of cash in the business over a certain period. If an investment is expected to result in a significant outflow of cash without a corresponding increase in inflow, it could negatively impact liquidity. Therefore, businesses need to ensure that the investment will generate enough returns to cover the initial cash outflow.

Secondly, businesses can use liquidity ratios, which are financial metrics used to determine a company's ability to pay off its short-term debts. The two most common liquidity ratios are the current ratio and the quick ratio. The current ratio is calculated by dividing current assets by current liabilities. A ratio above 1 indicates that the company has more assets than liabilities, suggesting good liquidity. The quick ratio, also known as the acid-test ratio, is a stricter measure as it excludes inventory from current assets. If these ratios decrease after an investment, it could indicate a negative impact on liquidity.

Lastly, businesses can assess the impact of an investment on working capital. Working capital is the difference between a company's current assets and current liabilities. It's a measure of a company's operational efficiency and short-term financial health. If an investment reduces working capital, it could indicate a negative impact on liquidity.

In conclusion, businesses need to carefully consider the potential impact of an investment on liquidity. By using cash flow forecasts, liquidity ratios, and assessing the impact on working capital, businesses can make informed decisions about their investments.