What is liquidity and why is it important? Liquidity is a concept that has a direct impact on individuals, companies, and the financial markets. Liquidity is the relative ease with which an individual or organization’s belongings can be bought or sold to raise capital in the short term. An interesting fun fact about liquidity is that the more a firm’s assets, the more it can raise liquidity on short notice.
In other words, what is liquidity?
Liquidity is the amount of cash that is readily available. In discussing what is liquidity in assets, we can say it’s the summation of assets that can be easily converted to cash. In terms of market liquidity, it refers to how easy it is for individuals or businesses to sell an investment. It also considers how big and available a market exists for that asset. Investors use the amount of liquidity a company has on hand to gauge a firm’s financial capacity.
Interestingly, liquidity also considers the quick metamorphism of its price. The more quickly an investment is transformed into cash, the more premium it will sell for. It is also worth noting that premium liquid assets trade at a fair value while illiquid assets may trade at a discount.
Types of liquidity
There are two main types of liquidity, respectively market liquidity and accounting liquidity.
· Accounting liquidity
Accounting liquidity can measure how easy it is for a company or individual to meet their financial responsibilities with whatever liquid assets they can access and with their ability to repay their debts according to schedule.
For instance, if someone wants to buy a washing machine that costs $1,000, the easiest way to obtain this would be to pay by cash. If the individual doesn’t have any money but has a collection full of rare toys that have been appraised at $1,000, it’s highly unlikely to find a person that would trade the washing machine for the toys. The collection owner would have to sell the toys, get the money, and then buy the washing machine.
The assets of the collector are quite illiquid. Therefore, it’s likely for them to not be worth their entire value from the get-go. Accounting liquidity includes comparing various liquid assets to current liabilities or financial responsibilities that come due in one year.
Accounting liquidity is measured by different ratios.
· Market liquidity
Market liquidity is the extent to which a certain market lets assets be sold or purchased at transparent and stable prices. In the washing machine and toy collection example, the market for the toys is too illiquid, so it doesn’t even exist.
Meanwhile, the stock market has a lot of liquidity. If the exchange has a high trading volume that selling does not dominate, the asking price and bid price will be very close.
The market becomes more liquid when the spread between ask and bid prices becomes tighter. However, when it increases, there is more illiquidity.
Compared to stock markets, real estate ones are less liquid. Meanwhile, other assets, such as currencies, commodities, contracts, or derivatives, have market liquidity influenced by their size and the number of open exchanges.
Back in March 2023 (March 13 to be more precise), there were 69.6 million Amazon.com Inc. shares that traded on various exchanges. Intel Corp. had only 48.1 million shares, making it less liquid in comparison. But when you take a look at Ford Motor Co., which had a 118.5 million share volume, you can see that it was the most liquid of the three.
What is liquidity in stocks?
In the same vein, liquidity in stocks generally refers to how quickly shares of a stock can be sold or bought without directly impacting the price of such stock. With this simple reasoning, stocks that have low liquidity may be a bit difficult to sell. If you own and have cause to sell your share in such a stock, you may have to take a bigger loss if you cannot sell your share when you need to sell it.
For this singular reason, it is important to consider the liquidity risk associated with the stocks you wish to invest. Liquidity risk is the deciding factor for investors to consider when finding a constant market to liquidate your stock that may prevent you from selling or buying when you wish.
What is liquidity in finance?
A company’s financial liquidity refers to the company’s ability to convert its current assets to meet its current needs. A company’s financial well-being is also a direct measure of its ability to generate cash well above its current liabilities. With different liquidity ratios, investors can determine if a company is worth its investment.
Two major standpoints serve as the determinant of a company’s liquidity position. The first determinant is the company’s ability to change assets to cash to take care of its short-term liabilities. The second determinant is its ability to take on a debt against its current asset. These two determinants are crucial indicators of a company’s financial health and cover the question of what is liquidity in finance.
Advantages of financial liquidity
- Liquid assets have equivalent public pricing for easy valuation
- Assets are associated with transaction costs or lower fees.
- Assets are the best form of short-term financial health measurement.
- Premium assets owned by individuals or organizations are easily exchanged for quick cash.
Disadvantages of financial liquidity
- Liquid assets may hold more value in the future, leading to a loss in future valuation
- Assets like special collectables may hold value beyond the current financial valuation.
Why is liquidity important?
If you are still wondering what liquidity is and why it is important, the simple answer is that it ensures that buying and selling can be executed in an orderly manner. For people in finance, they understand that buyers and sellers often trade assets based on market valuation and pending book orders. In situations where a specific stock or security on the market has no liquidity, market players cannot execute trades on it.
For these reasons, it is important to understand the financial ratios that are used to calculate a company’s liquidity.
How to determine a company’s liquidity
There are three important ratios you need to focus on when you wish to determine a company’s accounting liquidity. They are:
- Cash ratio
- Current ratio
- Quick ratio
Cash ratio: This ratio compares cash at hand to current company liabilities. A company is considered to be in an extremely strong financial position if it can meet its financial obligations with its cash at hand without the need to sell any other assets.
Current ratio: Another name for this ratio type is the working capital ratio. This ratio expresses a company’s ability to meet its short-term liability needs. It can meet this need by liquidating its current assets. The higher the current ratio, the stronger the company’s financial health.
Quick ratio: This ratio tends to use only the quick-liquid assets such as cash, marketable securities, and account receivable to measure how it can handle its short-term liabilities. This ratio type does not include inventory that is illiquid in the short term. It measures these quick current assets against its short-term liabilities.
The liquidity of an organization tells a lot about its financial well-being. The higher the liquidity of an organization, the easier it is for it to meet its financial obligations. Interestingly, these calculations are applicable on a personal basis. If an individual has more in savings and current assets than their debt, it directly translates to strong financial health.
Liquidity may seem a difficult term. However, our analyst Tony tried to explain everything as simply as possible. Don’t believe us? Then check out the video below!
Tony is a financial analyst of the Binomo team. He is a trader with many years of experience in the market. Tony is the face of our YouTube and Instagram channels and is doing everything to help traders achieve new heights.