What is liquidity?

In finance, liquidity refers to how easily an asset can be converted into cash without affecting its market value.

Cash is the most liquid asset because it can instantly be used for purchases or investments. Other assets, like stocks or bonds, are also liquid but may take longer to sell. On the other hand, assets like real estate, collectibles, or rare items are considered illiquid because selling them may incur higher transaction costs or a significant price reduction.

Liquidity is important for businesses because it determines their ability to meet short-term financial obligations, like paying bills or salaries or making urgent investments. If a company doesn’t have enough liquid assets, it may struggle to cover these costs – even if it owns valuable, but illiquid assets.

In financial markets, liquidity can also refer to how easily an investment can be sold without affecting its price. Highly liquid investments, such as stocks, trade quickly at market value, while illiquid investments may require price discounts to sell quickly.

Types of liquidity

Liquidity can be divided into two types: market liquidity and accounting liquidity.

Market liquidity

Market liquidity refers to how easily assets can be bought and sold within the market at stable, fair prices.

In the stock market, for example, there’s typically a high volume of trades, meaning buyers and sellers can agree on prices quickly without causing big price changes. The closer the bid price (what a buyer is willing to pay) is to the ask price (what a seller wants to accept), and the more liquid the market is.

On the other hand, the real estate market is often less liquid because it can take longer to find buyers and sellers, and prices can fluctuate more dramatically. Generally, the liquidity of any market depends on how many buyers and sellers are involved and how many exchanges are available for trading.

Accounting liquidity

Accounting liquidity measures how easily an individual or business can meet their financial obligations by converting their liquid assets into cash.

For example, consider a retail business that has $50,000 in cash and receivables but owes $40,000 in supplier payments. Since the business has enough liquid assets to cover its immediate liabilities, it’s in a strong liquidity position. However, if most of the business’s assets were tied up in unsold inventory or equipment, it may struggle to pay suppliers on time – even if those assets have value.

In short, accounting liquidity helps assess whether a company or individual can pay off its debt as they come due. It’s measured using financial ratios, which compare liquid assets to short-term liabilities. Stronger accounting liquidity means a business can more easily pay off its debts and manage its finances without cash flow issues.

How is liquidity measured?

Liquidity can be measured in different ways depending on the context (e.g. measuring market liquidity or a company’s financial health). Below are some ways to measure market and accounting liquidity.

Market liquidity

Market liquidity can be measured using the bid-ask spread and trading volume.

Bid-ask spread

The bid-ask spread measures the difference between the highest price a buyer is willing to pay (bid) and the lowest price a seller is willing to accept (ask) for an asset:

• When the bid-ask spread is narrow, it indicates high liquidity as transactions can happen quickly at agreeable prices.
• When the bid-ask spread is wide, it signals low liquidity as it’s harder for buyers and sellers to agree on a price.

For example, common stocks often have tight spreads of a few cents, while less frequently traded assets – like options or low-volume securities – might have spreads of several dollars.

Trading volume

Higher trading volume often leads to tighter bid-ask spreads, meaning higher liquidity. However, even in markets with wider spreads, high trading volume can make it easier for investors to buy or sell assets efficiently.

Accounting liquidity

Accounting liquidity refers to how well a company can meet its short-term financial obligations using liquid assets. This is typically measured using three financial ratios: current ratio, quick ratio, and cash ratio.

Current ratio (working capital ratio)

The current ratio compares a company’s current assets (i.e. cash, accounts receivable, inventory, etc.) to its current liabilities (i.e. debts or expenses due within a year). It’s calculated as:

Current Assets / Current Liabilities = Current Ratio

For example, if a company has $3 million in current assets and $2 million in current liabilities, its current ratio would be calculated as:

$3 million / $2 million = 1.5

A current ratio over 1 indicates the company has more liquid assets than liabilities. The higher the ratio, the better a business is able to meet its financial obligations.

Quick ratio (acid-test ratio)

The quick ratio, also known as the acid-test ratio, excludes inventory and prepaid expenses. It only focuses on cash and assets that can be quickly converted into cash (e.g. accounts receivable and short-term investments). It’s calculated as:

Cash + Marketable Securities + Accounts Receivable) / Current Liabilities = Quick Ratio

For example, if a company has $1 million in cash, $500,000 in accounts receivable, and $2 million in liabilities, its quick ratio would be calculated as:

($1 million + $500,000) / $2 million = 0.75.

This suggests that the business may struggle to meet its short-term obligations without selling other assets. Like the current ratio, a higher quick ratio indicates a more financially stable company.

Cash ratio

The cash ratio is the most conservative measure of a company’s liquidity. It only considers cash and cash equivalents relative to current liabilities, ignoring all other assets. It’s calculated as:

Cash / Current Liabilities = Cash Ratio

For example, if a business holds $2 million in cash and owes $1 million, its cash ratio would be 2, indicating high liquidity. Like other liquidity ratios, a cash ratio above 1 means a company is better situated to cover its liabilities with cash.

Why is liquidity essential for institutional investors and large corporations?

For companies and investors, liquidity plays an important role in understanding how easily an asset can be converted into cash without significantly affecting its value.

For investors, liquidity indicates flexibility. When an investor or institution holds a highly liquid asset, they know it can quickly be sold at a fair price. This flexibility is valuable in situations where cash is needed to cover emergency expenses or capitalize on a time-sensitive opportunity.

Investors also weigh liquidity against returns. While high liquidity is often desirable, it doesn’t always mean it’s better. Illiquid investments, such as private equity or real estate, may offer higher returns in exchange for the risk of being unable to exit a position without incurring losses or experiencing delays.

For businesses, liquidity is a valuable measure of financial health. Companies need liquid assets to meet their short-term obligations and be able to invest in growth opportunities like acquisitions or expansion. Businesses trading internationally may particularly benefit from FX liquidity for companies.

In financial markets, liquidity is important for smooth functioning. High liquidity means there’s plenty of buyers and sellers available, allowing trades to be executed quickly and at fair prices. These markets build investor confidence and encourage participation.

On the other hand, low liquidity in financial markets can cause challenges. For example, if the lending market was experiencing low liquidity, companies and individuals may struggle to secure loans. This may slow down the economy and lead to a cycle where a slower economy further reduces lending, which weakens the economy more, and makes liquidity even scarcer.

How do businesses maintain liquidity to ensure operational stability?

For businesses, maintaining liquidity is essential for operational stability and financial health. Some common liquidity management strategies include:

• Building cash reserves: Setting aside funds provides a financial buffer against unforeseen expenses or revenue shortfalls.
• Optimizing accounts payable & receivable: Companies can encourage clients and customers to pay early by offering discounts and following up on overdue invoices. They may also negotiate longer payment terms with suppliers to maintain positive cash flow without incurring late fees.
• Utilizing credit lines: Having access to credit facilities can provide businesses with additional flexibility to address short-term liquidity needs without overextending debt.
• Investing strategically: Balancing liquid assets with longer-term investments can help businesses optimize returns while ensuring enough cash is available for operational needs.
• Predicting cash flows: Accurate forecasting of cash inflows and outflows can allow businesses to plan for potential shortfalls or surpluses and make adjustments to maintain liquidity.
• Diversifying funding sources: Relying on multiple funding options, such as bank loans, investor capital, and internal funds, can reduce a business’s dependency on a single source.
• Utilizing liquidity services: Liquidity service providers provide customized liquidity solutions to help companies and institutional investors mitigate liquidity risk.

This material is for informational purposes only and should not be considered as an investment recommendation or a personal recommendation.