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What is Liquidity?

definition

Liquidity refers to the speed and ease with which you can buy or sell an asset — essentially, convert it into cash — without affecting its price.

🤔 Understanding liquidity

A liquid asset is cash — or an asset that you can quickly convert into cash at a reasonable price. Stocks and bonds are liquid assets, while real estate and equipment are not. Considering the liquidity of an investment is essential if you want to be able to buy or sell it on short notice. A company needs to have a certain degree of liquidity in order to meet short-term financial obligations, such as upcoming bills. Solvency, on the other hand, refers to a company’s ability to pay long-term debts. There are several different formulas for assessing a company’s liquidity.

example

Stocks have varying liquidity levels. Large-cap stocks (generally companies with a market value of at least $10 billion) are usually more liquid than small-cap stocks (usually companies with a market value between $250 million and $2 billion). That’s because there are more buyers and sellers for large-cap stocks. For instance, Apple is a very liquid stock — You can buy or sell it quickly at the market price. A large volume of Apple’s shares trade every day (the average is more than 25 million), so it’s easy to find a buyer or a seller. If you want to purchase or offload a stock with a lower trading volume, such as Freddie Mac, it could take more time. As a result, the stock is considered less liquid.

Takeaway

To understand liquidity, think about water...

Water is a liquid that’s ready to drink — You don’t have to transform it into something else first. But you can’t drink an ice cube as it is. You have to wait for it to melt and become water. Similarly, you can use cash right away to buy stuff — It’s liquid. But if you own a house, you need to sell it to have cash. That can take time, just like an ice cube takes time to melt into something you can drink.

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What is liquidity?
What is market liquidity?
What is accounting liquidity?
What are liquid assets?
How is liquidity measured?

What is liquidity?

Liquidity refers to how fast you can buy or sell an asset — convert it into cash — without affecting its price. Assets have varying degrees of liquidity. Cash is the most liquid asset because you can immediately and easily transform it into other assets.

To illustrate this, let’s say you want to buy a car that costs $10,000. You don’t have $10,000 on hand, but you own a painting that’s worth that amount. To get $10,000 in cash, you’ll have to sell your painting. But you may have to sell it at a discount if you need cash right away or can’t find a buyer willing to pay your desired price. So, a painting isn’t considered very liquid.

What is market liquidity?

Market liquidity, in economics or investing, refers to how quickly an asset can be sold without changing its price much or incurring high costs. The faster you can buy or sell an investment, the more liquid it is. Higher market liquidity means more buyers and sellers exist, so transactions can proceed smoothly. Market liquidity can be critical, since buying or selling your assets when you want can enable you to make a profit, avoid losses, or adapt to changes in your needs or the market context.

In a less liquid market, there are fewer buyers and sellers, and it’s harder to complete a transaction. The risk that you remain stuck with your investment or can’t sell it at your desired price goes up. Plus bid-ask spreads are larger than in a illiquid market. Bid-ask spread is the difference between the highest price buyers are ready to pay and the lowest price at which sellers want to sell. Since investors can’t sell illiquid investments whenever they want, they will generally ask for a higher return to compensate them for the higher risk they’re taking on.

What is accounting liquidity?

Accounting liquidity refers to a company’s ability to pay off current liabilities (debts) with current assets on hand.

Current assets are those expected to turn into cash within one year. The most common are cash, marketable securities (like stocks and bonds), inventory, and accounts receivable (money the company is owed for goods or services it has provided). Current liabilities are those expected to be paid off in less than a year. These include accounts payable (what a company owes creditors and suppliers in the short term), accrued expenses (expenses already incurred but not paid yet), and deferred revenue (payment received in advance for products or services not yet delivered). Companies report assets on their balance sheets, usually listing them from the most to the least liquid. Cash is at the top, while assets like property and equipment are near the bottom.

Solvency, like liquidity, is a way to measure a company’s financial health. The difference is that liquidity is a short-term concept, while solvency takes a long-term perspective. Solvency measures a company’s cash flow relative to all its liabilities, not just short-term debt. A highly solvent company is likely to continue operating for a long time into the future. A company can be highly solvent but have low liquidity and vice versa. To stay competitive, a company generally needs to be both liquid and solvent.

What are liquid assets?

Liquid assets are easy to convert to cash quickly without changing their value significantly. Generally, liquid assets are traded on an established market with a large number of buyers and sellers, such as a major exchange. Cash is the most liquid asset since you don’t need to sell it or convert it — It’s already cash.

Marketable securities such as stocks and bonds are usually very liquid. You can typically turn them into cash within a few days, depending on the size of the investment. Treasury bills (debt obligations issued by the U.S. government with a maturity of one year or less) and money market mutual funds are some of the most liquid debt securities. Exchange-traded funds (ETFs), which are investment funds traded on a stock exchange, are usually more liquid than mutual funds (managed investment funds that pool money from investors to buy securities) because they trade like stocks.

Illiquid assets are harder to convert to cash and may lose a lot of value in the process. Real estate is an illiquid asset because it can be challenging to sell a property quickly. There may also be a significant difference between the paper value of the property and the amount you actually get for it. Art and private businesses are also illiquid assets, since they can take months or years to sell. Many hedge funds also impose restrictions on withdrawing funds you’ve contributed, making them illiquid investments.

For businesses, liquidity is one of the critical factors that determine success. A company that has enough liquid assets will be able to meet its immediate financial obligations and operating expenses, such as payroll and supplier costs. A lack of liquidity could force a company to sell assets that it doesn’t want to get rid of. In the worst case, a company could end up declaring bankruptcy or closing down.

For individuals, having liquid assets is important to pay everyday expenses and deal with emergencies. If you don’t have enough cash on hand, you may be forced to go into high-interest debt when your car breaks down or an unexpected medical bill pops up. Retired people might prefer to own liquid investments so they can draw an income from their investment portfolio.

How is liquidity measured?

Rather than calculating the liquidity of each asset directly, businesses and analysts use financial ratios to assess the liquidity level of a company as a whole. Liquidity ratios show a company’s ability to turn assets into cash to pay off short-term debts. Here are the four main ratios used:

  1. Current ratio (working capital ratio): This measures a company’s ability to pay off short-term debts (those due within a year) with current assets (cash or things that can become cash within a year). A current ratio of 1 indicates that a company is just able to cover all its short-term obligations.

Current ratio = Current assets / Current liabilities

  1. Quick ratio (acid-test ratio): This measures a company’s ability to pay off short-term debts with quick assets (current assets that can be quickly converted into cash, such as marketable securities). For most industries, a quick ratio over 1 is good.

Quick ratio = (Cash + Cash equivalents + Account receivables) / Current liabilities

  1. Cash ratio: This measures a company’s ability to pay off short-term liabilities with cash and cash equivalents, which include money market accounts and U.S. Treasury bills. Creditors generally prefer a high cash ratio.

Cash ratio = (Cash + Cash equivalents) / Current liabilities

  1. Operating cash flow ratio: This shows the number of times a company can pay current debts with cash earned during the same period. You can find operating cash flow (cash coming from a company’s regular operations) on a company’s cash flow statement. A ratio lower than 1 is a potential warning sign, as it may show that a company can’t meet its obligations through normal business operations.

Operating cash flow ratio = Operating cash flow / Current liabilities

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