What Exactly Is Liquidity?
The efficiency or convenience with which an asset or security can be converted into immediate cash without influencing its market price is referred to as liquidity. Cash is the most liquid of all assets.
- The ease with which an asset, or security, can be changed into immediate cash without impacting its market price is referred to as liquidity.
- The most liquid asset is cash, while tangible assets are less liquid. Market liquidity and accounting liquidity are the two basic types of liquidity.
- Liquidity is typically measured using current, quick, and cash ratios.
Liquidity: An Overview
To put it another way, liquidity refers to the ease with which an item can be bought or sold in the market at a price that reflects its true value. Cash is usually regarded as the most liquid asset since it can be transformed into other assets quickly and easily. Real estate, fine art, and collectibles, for example, are all relatively illiquid assets. Other financial assets, such as equity and partnership units, fall into other liquidity categories.
If a person wants a $1,000 refrigerator, for example, cash is the asset that can be utilized to get it the quickest. If the person has no cash but a $1,000 rare book collection, it's unlikely that they'll be able to locate someone ready to trade the refrigerator for their collection. Instead, they'll have to sell the collection and use the proceeds to buy the fridge. That may be acceptable if the person has months or years to make the purchase, but it may be problematic if the person only has a few days. Instead of waiting for a buyer willing to pay full price, they may have to offer the books at a discount. A good example of an illiquid asset is rare books.
Market liquidity and accounting liquidity are the two basic metrics of liquidity:
Liquidity of the market
The extent to which a market, such as a country's stock market or a city's real estate market, permits assets to be bought and sold at steady, transparent prices is referred to as market liquidity. The market for refrigerators in exchange for rare books in the scenario above is so illiquid that it effectively does not exist.
On the other side, the stock market has a larger level of market liquidity. The price a buyer offers per share (the bid price) and the price a seller is ready to take (the asking price) will be pretty close to each other if an exchange has a significant volume of transactions that is not dominated by selling.
Investors will no longer have to forego unrealized gains in exchange for a rapid sale. The market becomes more illiquid as the spread between the bid and ask prices widens. Real estate markets are typically less liquid than stock markets. Market liquidity for other assets, such as derivatives, contracts, currencies, and commodities, is frequently determined by their size and the number of open exchanges on which they can be traded.
Liquidity in Accounting
Accounting liquidity refers to a person's or a company's capacity to satisfy financial obligations with the liquid assets at hand—the ability to pay off debts when they become due.
In the case above, the rare book collector's assets are relatively illiquid, and in a pinch, they would probably not be worth $1,000. Accounting liquidity is determined by comparing liquid assets to current liabilities, or financial obligations that are due within a year.
There are several accounting liquidity ratios available, each with its own definition of "liquid assets." These are used by analysts and investors to find organizations with high liquidity. It's also used as a gauge of depth.
Financial analysts examine a company's ability to cover short-term obligations using liquid assets. When employing these calculations, a ratio greater than one is generally preferred.
The current ratio is the most straightforward and least stringent. It compares current assets (those that can be converted into cash in less than a year) to current liabilities (those that can be converted into cash in less than a year). Its formula would be as follows:
Current Ratio = Current Assets / Current Liabilities
Quick Ratio (Acid-test ratio)
The fast ratio, often known as the acid-test ratio, is a little more stringent. Inventory and other current assets are not included since they are not as liquid as cash and cash equivalents, accounts receivable, and short-term investments. The formula is as follows:
Quick Ratio = (Cash and Cash Equivalents + Short-Term Investments + Accounts Receivable) / Current Liabilities
Acid-Test Ratio (Variation)
A slightly more lenient version of the quick/acid-test ratio just subtracts inventory from current assets: Acid-Test Ratio (Variation) = (Current Assets - Inventories - Prepaid Costs) / Current Liabilities
The most exacting of the liquidity criteria is the cash ratio. It defines liquid assets strictly as cash or cash equivalents, excluding accounts receivable, inventory, and other current assets.
The cash ratio, more than the current or acid-test ratios, evaluates an entity's ability to be solvent in the event of an emergency—the worst-case scenario—on the basis that even highly lucrative businesses can go bankrupt if they lack the liquidity to react to unforeseen occurrences. Its formula is as follows:
Cash Ratio = Cash and Cash Equivalents / Current Liabilities
Example of Liquidity
Equities are one of the most liquid asset classes in terms of investments. When it comes to liquidity, though, not all stocks are made equal. On stock exchanges, certain shares trade more actively than others, indicating that there is a larger demand for them. In other words, they pique the interest of traders and investors more frequently and consistently. The daily volume of these liquid equities, which can be in the millions or even hundreds of millions of shares, helps to identify them.
On April 26, 2019, for example, 8.4 million shares of Amazon.com (AMZN) were traded on the NASDAQ. While that may appear to be adequate liquidity, it pales in comparison to Intel (INTC), which led the NASDAQ that day with 72 million shares traded, or Ford Motor (F), which led the New York Stock Exchange (NYSE) with 156 million shares traded, making it the most liquid stock in the United States that day.
What Is the Importance of Liquidity?
It becomes difficult to sell or convert assets or securities into cash if markets are not liquid. For example, you might hold a $150,000 family heirloom that is extremely rare and precious. However, if your object has no market (i.e. no buyers), it is meaningless because no one will pay anywhere near its rated value—it is extremely illiquid. It may even be necessary to hire an auction house to act as a broker and locate potential buyers, which may take time and money.
Liquid assets, on the other hand, can be swiftly and readily sold for their full value at a low cost. Companies must also have sufficient liquid assets to satisfy short-term obligations such as bills and payments, or else suffer a liquidity crisis that could lead to insolvency.
What Assets or Securities Have the Most Liquidity?
The most liquid asset is cash, which is followed by cash equivalents such as money markets, CDs, and term deposits. Exchange-listed marketable instruments, such as stocks and bonds, are frequently quite liquid and may be sold immediately through a broker. Gold coins and some collectibles can also be sold for money.
What Are Some Examples of Illiquid Securities or Assets?
Over-the-counter (OTC) securities, such as certain complicated derivatives, are frequently illiquid. Individually, a home, a timeshare, or a car are all illiquid in the sense that finding a buyer and finalizing the deal and receiving payment can take many weeks to months. Furthermore, broker fees are frequently fairly high (e.g., 5-7 percent on average for a realtor).
Why Are Some Stocks Liquid While Others Aren't?
Stocks with a lot of interest from multiple market participants and a lot of daily transaction volume tend to be the most liquid. These equities will also attract more market makers, resulting in a tighter two-sided market. Stocks that are less liquid have broader bid-ask spreads and less market depth. These are less well-known names with lower trading volume, as well as lower market value and volatility. As a result, a large multi-national bank's stock will be more liquid than a small regional bank's.
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