What is liquidity?
Liquidity describes the extent to which an asset or security can be quickly bought or sold on the market at a price that reflects its intrinsic value. In other words: the ease of converting it to cash.
Cash is universally considered the most liquid asset, while tangible assets, such as real estate, fine art and collectibles, are all relatively illiquid. Other financial assets, ranging from equities to partnership shares, are found at various points in the liquidity spectrum.
Why is liquidity important?
The basics of liquidity
Cash is considered the standard for liquidity because it can be quickly and easily converted to other assets.
If a person wants a $ 1,000 refrigerator, cash is the most easily used asset to get it. If this person has no money, but a rare book collection that has been valued at $ 1,000, it is unlikely that they will find someone willing to exchange the refrigerator for their collection. Instead, she will have to sell the collection and use the money to buy the refrigerator. It may be fine if the person can wait months or years to make the purchase, but it can be a problem if they only have a few days. He / she may have to sell the books at a reduced price, instead of waiting for a buyer willing to pay the full value. Rare books are an example of an illiquid asset.
Key points to remember
- Liquidity indicates whether there is a ready market for an asset – the ease of converting it to cash.
- Money is the most liquid of assets; tangible elements, among the least liquid.
- There are different ways to measure liquidity, including market liquidity and accounting liquidity.
Market liquidity refers to the extent to which a market, such as a country’s stock exchange or a city’s real estate market, makes it possible to buy and sell assets at stable and transparent prices.
In the example above, the market for refrigerators in exchange for rare books is so illiquid that, for all intents and purposes, it does not exist. The stock market, on the other hand, is characterized by higher market liquidity. If a trade has a high trading volume that is not dominated by the sale, the price a buyer offers per share (the offer price) and the price the seller is willing to accept (the price asked) will be fairly close to each other. Investors will therefore not have to give up unrealized gains for a quick sale. When the spread between bid and ask prices increases, the market becomes more liquid.
Real estate markets are generally much less liquid than stock markets. The liquidity of markets for other assets, such as derivatives, contracts, currencies or commodities, often depends on their size and the number of open trades on which they can be traded.
Accounting liquidity measures the ease with which a person or a business can meet its financial obligations with the liquidity at its disposal – the ability to repay debts when they fall due. In the example above, the assets of the rare book collector are relatively illiquid and are probably not worth their full value of $ 1000 if need be.
In terms of investment, assessing accounting liquidity means comparing liquid assets with current liabilities or financial obligations that mature within one year. There are a number of ratios that measure accounting liquidity, which differ in how they strictly define “liquid assets”. Analysts and investors use them to identify companies with high liquidity. It is also considered a measure of depth.
Measure accounting liquidity
Generally, using these formulas, a ratio greater than one is desirable.
The current ratio is the simplest and the least strict. It measures current assets (those that can reasonably be converted to cash in one year) against current liabilities. Its formula would be:
Current ratio = current assets / current liabilities
Acid test / quick report
The acid test or rapid report is slightly more stringent. It excludes inventories and other current assets, which are not as liquid as cash and cash equivalents, accounts receivable and short-term investments. As formula:
Test acid ratio = (Cash and cash equivalents + Short-term investments + Accounts receivable) / Current liabilities
A variation in the acid-test ratio simply subtracts the inventory of current assets, which makes it a little more generous:
Test acid ratio (Var) = (Current assets – Stocks – Prepaid costs) / Current liabilities
The cash ratio is the most demanding of the liquidity ratios. Excluding accounts receivable, as well as inventories and other current assets, it defines liquid assets strictly as cash or cash equivalents. More than the current ratio or the acid-test ratio, it assesses the capacity of an entity to remain solvent in an emergency – in the worst case – on the grounds that even very profitable companies can have problems if they do not have the liquidity to react to unforeseen events. Its formula:
Cash ratio = (cash and cash equivalents + short-term investments) / current liabilities
Example of real-world liquidity
In terms of investments, stocks as a class are among the most liquid assets. But not all shares are created equal in terms of liquidity. Some stocks trade more actively than others on the stock market, which means there is more market for them – they attract more and more constant interest from traders and investors, in other words . These liquid shares are generally identifiable by their daily volume, which can reach millions of shares, even hundreds of millions.
For example, on April 26, 2019, 8.2 million shares of Amazon.com (AMZN) were traded on the Nasdaq. As liquid as it sounds, it’s not a drop in the bucket compared to Intel (INTC), which led the Nasdaq that day, with a volume of 71.5 million shares – or Ford Motor (F), which led the New York Stock Exchange with a volume of 154.8 million shares, making it the most liquid security in the United States that day.