When the asset or security can be converted into ready cash efficiently without affecting its marketplace, it is referred to as Liquidity. Cash itself is the most liquid asset of all time. Making the availability of cash easier for such conversions is the biggest influence on whether a market can move efficiently.
The higher the liquidity of an asset, the simpler and more effective it is to convert it back into cash. Less liquid assets typically require more time and may incur greater costs.
Comprehension of Liquidity
Liquidity can be described as the degree to which an asset can be quickly bought or sold in the market at a price reflecting its true value. Cash is the most liquid asset because of its quickness and easy conversion into other assets making it a universally famous liquid asset.
Tangible assets, like property, fine art, and collectibles, are classified as illiquid. Other financial assets, ranging from equities to partnership units, fall into various places in the liquidity spectrum.
For example, if a person wants a $2,000 air conditioner, cash is the asset that can most easily be used to obtain it. If that person has no cash but a rare book collection that has been appraised at $2,000, they are unlikely to find someone willing to trade the air conditioner for their collection. Instead, they will have to sell the collection and use the cash to purchase the air conditioner.
That may be acceptable if someone can wait for several months or even years before purchasing. In the case of an emergency, they may have to sell the books at a discount, instead of waiting for a buyer who is willing to pay the full value. Rare books are an illiquid asset.
Types of Liquidity
There are two types of Liquidity available:
- Market liquidity
- Accounting liquidity
1. Market Liquidity
Market liquidity refers to a market, such as a country’s stock market that allows assets to be bought and sold at transparent prices. In the example above, the market for air conditioners in exchange for rare books is such an illiquid asset that it does not exist.
The stock market is characterized by higher market liquidity. If an exchange has a high volume of trade, the bid price and the asking price will be fairly close to each other.
When the spread between the bid price and the ask price narrows, the market is more liquid. When the spread widens, the market becomes less liquid. Properties are less liquid than Stock markets. The liquidity of markets for other assets, like, contracts, currencies, or commodities, often depends on their size and how many open exchanges exist for them to be traded on.
2. Accounting Liquidity
Accounting liquidity refers to the ease with which a company can meet its financial obligations with the liquid assets available to them. It can also be framed as the ability to pay off debts as they come due to a company.
In the example above, the rare book collector’s assets are relatively illiquid and not worth their full value of $2,000 in a pinch. In investment terms, accounting liquidity means comparing liquid assets to current liabilities that come due within one year. Analysts and investors use this method to identify companies with strong liquidity. It is also considered as a measure of depth.
How to Measure Liquidity?
When a financial analyst checks the company’s ability to use liquid assets to cover its short-term obligations, they take the help of different ratios to measure it. The following are those ratios:
1. Current Ratio: The current ratio is known as the simplest and least strict method to measure Liquidity. It calculates the current assets (those that can be easily converted into cash within a year) in case of current liabilities. Its formula would be:
The current Ratio can be calculated as, Current Assets / Current Liabilities.
2. Quick Ratio (Acid-Test Ratio): The quick ratio, or acid-test ratio, is considered to be slightly stricter than the Current Ratio. It debars inventories and several current assets, that are not much liquid as cash and cash equivalents, accounts receivable, and short-term investments. The formula is:
Quick Ratio = (Cash and Cash Equivalents + Short-Term Investments + Accounts Receivable) ÷ Current Liabilities
3. Acid-Test Ratio (Variation): An alternative version of the quick/acid-test ratio involves deducting inventory from current assets, which makes it slightly more lenient.
Acid-Test Ratio (Variation) is calculated as (Current Assets – Inventories – Prepaid Costs) divided by Current Liabilities.
4. Cash Ratio: The Cash ratio excludes accounts receivable, as well as inventories and other current assets, and it also defines liquid assets strictly as cash or cash equivalents.
The cash ratio assesses more entity’s ability to stay solvent than the current ratio or acid-test ratio, in case of an emergency. Its formula is:
Cash Ratio is measured by Cash and Cash Equivalents divided by Current Liabilities
Why is Liquidity important?
Liquidity is essential because if the markets lack liquidity, it becomes challenging to sell or convert assets or securities into cash. For example, you might own a very rare and valuable family heirloom appraised at $250,000.
However, if there is no market for your item, then its value becomes irrelevant since nobody will pay anywhere near its appraised value, making it very illiquid. It may even require hiring an auction house to act as a broker and find interested parties, which will take time and incur costs.
Liquid assets, on the other hand, can be easily and quickly sold for their full value. Companies need to keep enough cash or cash-like assets on hand to pay their short-term bills, like payroll. If they don’t, they could run into a cash shortage, which might lead to bankruptcy.
What Are the Most Liquid Assets or Securities?
Cash is considered to be the most liquid asset around the globe, followed by cash equivalents, which are things like money market accounts, and certificates of deposits. Marketable securities, such as stocks are listed on exchanges that are often very liquid and can be sold quickly through a broker. Gold coins and specific collectibles can also be willingly sold for cash.
What Are Some Illiquid Assets or Securities?
Securities that are traded over the counter, such as certain complex derivatives, are often quite illiquid. For individuals, a home, or a car is somewhat illiquid it may take several weeks to months to find a buyer, and a few more weeks to finalize the transaction and receive payment.
Why are Some Stocks more Liquid than Others?
You may think why are some stocks more liquid than others? The answer to this is that the most liquid stocks tend to be those with a great deal of interest from various markets. Such stocks will also attract a larger number of market makers who maintain a two-sided market.
Illiquid stocks are known to have much wider bid-ask spreads and less market depth. These have lower trading volume and often have lower market value and volatility. Therefore, the stock of a large multinational bank will tend to be more liquid than that of a small regional bank.
Conclusion
The liquidity of a company refers to its ability to meet its financial obligations. It is a crucial financial measure that investors and creditors look at when analyzing a firm. A liquidity ratio greater than 1.0 is desirable, as it indicates that a company has enough assets to cover its liabilities. This is important for attracting investors and getting approved for loans.