What is Liquidity?
Liquidity is a representation of how quickly an asset or security can be converted into cash, i.e. liquidated or sold. Liquidity is a key component when trading in the financial markets; liquid securities can be sold more quickly than less liquid securities. Typically, the more liquid assets trade at a premium since they can be sold easily without any negative impact on their price, while illiquid assets trade at a discount since they may be difficult to sell and this can put pressure on the price.
The term liquidity is also used in accounting and refers to how easily a company can meet its short-term financial obligations.
Key Learning Points
- Liquidity is a financial metric that is used to determine how quickly an asset can be converted into cash without a negative impact on its fair price.
- Cash is considered to be the most liquid asset of all, while real assets (for example property) and private companies are typically the least liquid.
- Liquidity in accounting refers to a company’s ability to pay debts as they come due using only liquid assets. It can also be used to judge an entity’s solvency.
- Depending on the objective of the analysis, liquidity can be determined by financial ratios or by applying scenario analysis.
How Does Liquidity Work?
It is extremely important for both potential and existing investors, as well as business owners, to understand the liquidity of a stock or other asset. Usually, securities like equities and bonds offer a high level of liquidity, while tangible assets such as property take more time to convert into cash and may not necessarily sell for a price that represents fair value. A lack of liquidity causes liquidity risk. As a rule of thumb, the higher the demand for an asset, the greater its liquidity as it will be quicker to find a buyer (or seller) for that particular asset.
Types of Liquidity
Market liquidity defines the market conditions in which an asset can be purchased or sold. A market that can match a high number of buyers and sellers is considered to be liquid. In such a market, it would be relatively easy to dispose of an asset at its fair price. An illiquid market supports fewer buyers and sellers, making it much more difficult to liquidate an asset at the seller’s desired price. During periods of market stress, financial markets become more illiquid as sellers outnumber buyers.
Market liquidity can also be applied to other segments of the economy such as the real estate market or the high-end art market.
Liquidity in Stocks
A stock’s liquidity refers to how easily the shares of a publicly traded company can be sold. Typically, companies with larger market capitalizations, also called “blue-chip” stocks, are more liquid than shares in smaller companies. While supply and demand are key factors, aspects like risk (smaller cap stocks are considered riskier) and company specifics like earnings results could drive market activity. Investment managers watch the liquidity in their portfolios closely and regularly apply scenario analysis to determine how long it would take to liquidate a position. This exercise considers the average daily market volumes over a specific period (for example 90 days) and the level of market activity. The same can be applied to other assets such as bonds.
How Liquid are Stocks?
Cash is considered to be the most liquid of all asset classes. Other major asset classes can be ranked from most to least liquid as follows:
- Foreign Currency
- Fixed Income
- Public Equities
- Real Estate
- Private Companies
Liquidity in Accounting
Accounting liquidity describes a company’s solvency. It compares the company’s assets to its liabilities. Should the total assets exceed the liabilities, financial obligations can be met and the company will have working capital remaining. When analyzing a company, investors look at cash, investments, inventory, and accounts receivable to determine the liquidity position. Liquidity can be a good indicator of a company’s overall financial health.
How to Calculate Liquidity?
There are various techniques that can be used to assess liquidity, but financial ratios are the most widely used.
This is the most basic liquidity calculation. It measures total current assets, such as cash and assets that can be easily converted into cash (for example over a one-year period), against total current liabilities.
Current Ratio = Current Assets / Current Liabilities
Also known as the “Acid Test”, this ratio is more stringent and takes into account liquid assets such as cash and cash equivalents, marketable securities, and accounts receivable against current liabilities. It also excludes inventories and other current assets, which are more difficult to sell.
Current Assets – Inventory / Current Liabilities
As the name suggests, the cash ratio is more rigorous and takes into account only the company’s cash and cash equivalents, while excluding accounts receivables, inventories, and other current assets. Essentially, the cash ratio measures the company’s ability to stay solvent in the case of an emergency.
Cash Ratio Formula
Cash Ratio = Cash and Cash Equivalents / Current Liabilities
Deep dive into liquidity ratios with our new Accounting Ratios playlist as part of our online investment banking course.
Liquidity Example (Balance Sheet)
Usually, the information necessary to determine liquidity can be found on a company’s balance sheet. Assets are listed in order of liquidity. Since cash is the most liquid asset, it is typically listed at the top of the balance sheet. Also listed are the company’s liabilities.
The free download shows an example of a liquidity balance sheet.