- Liquidity refers to how much cash is readily available, or how quickly something can be converted to cash.
- Market liquidity applies to how easy it is to sell an investment – how big and constant a market there is for it.
- Accounting liquidity refers to the amount of ready money a company has on hand; investors use it to gauge a firm’s financial health.
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Liquidity may take on a different meaning depending on the context, but it always has to do with one thing: cash, or ready money.
Liquidity refers to the amount of money that is promptly available to meet debts or to use for investment. It indicates the levels of cash available and how quickly a financial asset or security can be converted into cash without losing significant value. In other words, how long it takes to sell.
Liquidity is important because it shows how flexible a company is in meeting its financial obligations and unexpected costs. It also applies to the average individual as well. The greater their liquid assets (cash savings and investment portfolio) compared to their debts, the better their financial situation.
Types of liquidity
Liquidity comes in two basic forms: market liquidity, which applies to investments and assets, and accounting liquidity, which applies to corporate or personal finances.
Market liquidity refers to the liquidity of an asset and how quickly it can be turned into cash. In effect, how marketable it is, at prices that are stable and transparent.
High market liquidity means that there is a high supply and a high demand for an asset and that there will always be sellers and buyers for that asset. If someone wants to sell an asset yet there is no one to buy it, then it cannot be liquid.
Liquidity is not the same thing as profitability. Shares of a publicly traded company, for example, are liquid: They can be sold quickly on a stock exchange, even if they have dropped in value. There will always be someone to buy them.
When investing, it is important for an investor to bear in mind the liquidity of a particular asset or security. Among investments and financial vehicles, the most liquid assets include:
- Savings/money market accounts
- Stocks traded on major exchanges and exchange-traded funds
- US government bonds
- Commercial paper
- Other short-term money-market securities
These all can be sold quickly at their fair value in return for cash.
Examples of illiquid assets, or those that can not be converted to cash quickly, tend to be tangible things, like real estate and fine art. They also include securities that trade on foreign stock exchanges, or penny stocks, which trade over the counter.
These items all take a long time to sell.
Accounting liquidity refers to a company’s or a person’s ability to meet their financial obligations â€” aka the money they owe on an ongoing basis.
With individuals, figuring liquidity is a matter of comparing their debts to the amount of cash they have in the bank or the marketable securities in their investment accounts.
With companies, it gets a tad more complex. Liquidity takes a look at a company’s current assets versus its current liabilities.
Why liquidity is important
The higher their liquidity, the better the financial health of a business or a person is.
For example, say a company had a monthly loan payment of $US5,000. Its sales are doing well and the company is realising profits. It has no issues in meeting its $US5,000 monthly obligation.
Now say the economy suffered a sudden economic downturn. Demand for the business’s products has vanished so, therefore, it is not bringing in revenue and making profits; however, it still has to meet its $US5,000 monthly loan bill.
Unfortunately, the company only has $US3,000 of cash on hand and no liquid assets to quickly sell for cash. It will default on its loan within one month. Now if the company had $US10,000 in cash and other liquid assets worth $US15,000 that it could sell in a few days for cash, it would be able to meet its debt obligations for many months to come, hopefully until the economy rebounds.
The same holds for human beings. The more savings an individual has the easier it is for them to pay their debts, such as their mortgage, car loan, or credit card bills. This particularly rings true if the individual loses their job and immediate source of new income. The more cash they have on hand and more liquid assets they can sell for cash, the easier it will be for them to continue to make their debt payments while they look for a new job.
Determining a company’s liquidity
Three liquidity ratios are primarily used to measure a company’s accounting liquidity:
- Current ratio
- Quick ratio
- Cash ratio
Current ratio basics
The current ratio, also known as the working capital ratio, seeks to determine a company’s ability to meet its short-term obligations that are due within a year. It is calculated as:
The higher the ratio, the better a company’s financial health is and the stronger its ability to meet its financial obligations.
For example, if a company has current assets of $US3 million and current liabilities of $US2 million, it will have a current ratio of 3/2 = 1.5. Now, if it has current assets of $US8 million and current liabilities remain at $US2 million, it will have a current ratio of 8/2 = 4.
Quick ratio basics
The quick ratio, aka the acid test ratio, also measures current assets against current liabilities.
However, in its calculation of current assets, it only uses the most liquid assets: cash, marketable securities, and accounts receivable. It does not include inventory, which the current ratio does, as inventory cannot be sold as quickly as the other assets.
There are actually two formulas for the quick ratio:
Again, the higher the ratio, the better a company is situated to meet its financial obligations.
Cash ratio basics
The cash ratio is an even more stringent ratio than the quick ratio. It compares only cash to current liabilities. If a company can meet its financial obligations through just cash without the need to sell any other assets, it is an extremely strong financial position.
The cash ratio is calculated as:
What liquidity ratios can tell you
A company’s liquidity can be a key factor in deciding whether to invest in its stock or buy its corporate bonds.
High liquidity ratios indicate a company is on a strong financial footing to pay its debt. Low liquidity ratios indicate that a company has a higher likelihood of defaulting, particularly if there is a downturn in its specific market or the overall economy.
Whatever the ratio you’re using:
- A value of 1 indicates that a company has current assets equal to current liabilities.
- A value above 1 indicates that a company has more current assets than current liabilities.
- A value below 1 indicates that a company has more current liabilities than current assets and is not in a position to meet its financial obligations.
(For the cash ratio the values would relate to just cash as opposed to all current assets.)
When comparing liquidity ratios, it is important to only compare companies within the same industry. This is because every type of industry is going to have different asset and debt requirements.
For example, a technology company does not operate the same as an airline company. The tech firm might need to buy computers and office space, while an airline needs to buy planes, a large labour force, and jet fuel. So it’s natural for an airline company to carry higher levels of debt.
Financial analyst reports on companies often include liquidity ratios. Otherwise, an investor might have to calculate it themselves, using the info reported on a company’s financial statements or in its annual report.
The financial takeaway
Liquidity refers to the amount of money an individual or corporation has on hand and the ability to quickly convert assets into cash. The higher the liquidity, the easier it is to meet financial obligations, whether you’re a business or a human being.
If a person has more savings than they do debt, it means they are more financially liquid.
Companies with higher levels of cash and assets that can be readily converted to cash indicate a strong financial position as they have the ability to meet their debts and expenses, and, therefore, are better investments.
The liquidity of a particular investment is important as it indicates the level of supply and demand of that security or asset â€” and how quickly it can be sold for cash when needed.
Related Coverage in Investing:
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