What is Liquidity?
Liquidity in simple terms refers to how quickly something can be converted into cash without diminishing in value. For example, infrastructure and housing are not easily liquidated whilst shares and stocks are liquid assets.
The quick conversion of assets to cash is an important feature of liquidity. If you need money and have a fixed asset like a car, it might be more difficult to get the car sold at exactly the value of the car. This also depends on how quickly you want the cash and the unavailability of an immediate buyer. Therefore, a car is not a liquid asset.
Liquidity terminologies
In accounting, liquidity refers to the capacity of a company to settle its current debts with current assets. The current assets, like stocks, bonds, and cash refer to those that can be turned into cash within a year. The current debts are debts that are required to be paid off in a year. Solvency refers to the proportion of a company’s cash flows as compared to its debt in the long term, rather than within a year. Both liquidity and solvency are measures of a company’s financial performance.
Liquid assets refer to assets that are very easy to convert to cash without altering their value. Cash is the most liquid asset. If you purchase a treasury bill, ETF, or mutual fund, you can typically trade it for money within a couple of days.
Illiquid assets are difficult to convert to cash. These include anything from private businesses to art and real estate since they can take many months to sell. Market liquidity refers to how quickly you can sell an asset without changing its price. In a more liquid market, trading happens constantly hence sellers can easily find buyers without having to undervalue their assets. The reverse is true for a less liquid market.
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Considerations of liquidity in investing
When investing, it is important to assess the liquidity of said investment before you make the move. A company listed on the stock exchange would have met some minimum standard of liquidity to be able to take care of short-term finances. Its solvency would also determine the potential to settle long-term debts.
Stocks differ in their liquidity. Small-cap companies typically have fewer liquid stocks than large-cap companies. A large-cap company does frequent trading, with more buyers and sellers and that makes it more liquid than a small-cap company. The trading volume of the stock is also a good indicator of how liquid the stock is.
Measures of Liquidity
Liquidity can be measured by the working capital ratio which is the current assets divided by the current liabilities. A liquidity ratio of above one is ideal. Another measure is the quick “acid-test” ratio which is the sum of cash, cash equivalents, and account receivables divided by the current liabilities. A quick ratio that is more than 1 is also ideal for most companies.
The cash ratio is another measure that is calculated by dividing the cash and cash equivalents by the current liabilities. A high cash ratio is useful when going for credit. The operating cash flow ratio is calculated by dividing the operating cash flow by the current liabilities. An operating cash flow ratio of more than one is usually a bad sign.
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Conclusion
When investing in a company or the stock market, gauging the liquidity of the asset is important in determining how you would invest. Illiquid assets may be great status symbols but may carry more risks for you when it comes to converting them to cash and a company with low liquidity may be one you have to be very wary of.
