Liquidity

Loading the player...

What is 'Liquidity'

Liquidity describes the degree to which an asset or security can be quickly bought or sold in the market without affecting the asset's price.

Market liquidity refers to the extent to which a market, such as a country's stock market or a city's real estate market, allows assets to be bought and sold at stable prices. Cash is the most liquid asset, while real estate, fine art and collectibles are all relatively illiquid.

Accounting liquidity measures the ease with which an individual or company can meet their financial obligations with the liquid assets available to them. There are several ratios that express accounting liquidity.

BREAKING DOWN 'Liquidity'

Cash is considered the standard for liquidity because it can most quickly and easily be converted into other assets. If a person wants a $1,000 refrigerator, cash is the asset that can most easily be used to obtain it. If that person has no cash, but a rare book collection that has been appraised at $1,000, they are unlikely to find someone willing to trade them the refrigerator for their collection. Instead, they will have to sell the collection and use the cash to purchase the refrigerator. That may be fine if the person can wait months or years to make the purchase, but it could present a problem if the person only had a few days. They may have to sell the books at a discount, instead of waiting for a buyer who was willing to pay the full value. Rare books are therefore an illiquid asset.

Market Liquidity

In the example given 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 an exchange has a high volume of trade that is not dominated by selling, the price a buyer offers per share (the bid price) and the price the seller is willing to accept (the ask price) will be fairly close to each other. Investors, then, will not have to give up unrealized gains for a quick sale. When the spread between the bid and ask prices grows, the market becomes more illiquid. Markets for real estate are pretty much inherently less liquid than stock markets. Even by the standard of real estate markets, however, a buyer's market is relatively illiquid, since buyers can demand steep discounts from sellers who want to offload their properties quickly. 

Accounting Liquidity

For an entity, such as a person or a company, accounting liquidity is a measure of their ability to pay off debts as they come due, that is, to have access to their money when they need it. In the example above, the rare book collector's assets are relatively illiquid, and would probably not be worth their full value of $1,000 in a pinch. In practical terms, assessing accounting liquidity means comparing liquid assets to current liabilities, or financial obligations that come due within one year. There are a number of ratios that measure accounting liquidity, which differ in how strictly they define "liquid assets."

Current Ratio

The current ratio is the simplest and least strict ratio. Current assets are those that can reasonably be converted to cash in one year.

Current Ratio = Current Assets / Current Liabilities

Acid-Test or Quick Ratio 

The acid-test or quick ratio is slightly more strict. It excludes inventories and other current assets, which are not as liquid as cash and cash equivalents, accounts receivable and short-term investments.

Acid-Test Ratio = (Cash and Cash Equivalents + Short-Term Investments + Accounts Receivable) / Current Liabilities

A variation of the acid-test ratio simply subtracts inventory from current assets, making it a bit more generous than the version listed above:

Acid-Test Ratio (Var) = (Current Assets - Inventories) / Current Liabilities

Cash Ratio

The cash ratio is the most exacting of the liquidity ratios, excluding accounts receivable as well as inventories and other current assets. More than the current ratio or acid-test ratio, it assess an entity's ability to stay solvent in the case of an emergency. Even highly profitable companies can run into trouble if they do not have the liquidity to react to unforeseen events.

Cash Ratio = (Cash and Cash Equivalents + Short-Term Investments) / Current Liabilities

For more, check Liquidity Measurement Ratios.

RELATED TERMS
  1. Acid-Test Ratio

    A stringent indicator that indicates whether a firm has sufficient ...
  2. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. ...
  3. Current Ratio

    The current ratio is a liquidity ratio measuring a company's ...
  4. Current Assets

    A balance sheet account that represents the value of all assets ...
  5. Cash Asset Ratio

    The current value of marketable securities and cash, divided ...
  6. Cash Ratio

    The ratio of a company's total cash and cash equivalents to its ...
Related Articles
  1. Options & Futures

    Understanding Financial Liquidity

    Understanding how this measure works in the market can help keep your finances afloat.
  2. Economics

    What is the Cash Ratio?

    The cash ratio is the ratio of a company's total cash and cash equivalents to its current liabilities.
  3. Fundamental Analysis

    Financial Analysis: Solvency Vs. Liquidity Ratios

    Solvency and liquidity are equally important for a company's financial health. A number of financial ratios are used to measure a company’s liquidity and solvency, and an investor should use ...
  4. Fundamental Analysis

    Dynamic Current Ratio: What It Is And How To Use It

    Learn why this ratio may be a good alternative to the current, cash and quick ratios.
  5. Investing Basics

    Do Your Investments Have Short-Term Health?

    If a company is strong enough to survive tough times, it is more likely to provide long-term value.
  6. Term

    What Are Quick Assets?

    A company’s quick assets can be easily converted into cash.
  7. Active Trading

    Understanding Liquidity Risk

    Make sure that your trades are safe by learning how to measure the liquidity risk.
  8. Term

    What is Liquidity Risk?

    Liquidity risk is the risk of being unable to sell an asset fast enough to avoid loss.
  9. Investing Basics

    Understanding Liquidity Risk

    Learn about the two types of liquidity risk: funding liquidity risk and market liquidity risk.
  10. Investing Basics

    The Working Capital Position

    Learn how to correctly analyze a company's liquidity and beat the average investor.
RELATED FAQS
  1. What is the relationship between the cash ratio and liquidity?

    Understand the relationship between a company's cash ratio and its liquidity. Learn what the cash ratio measures and what ... Read Answer >>
  2. What are some alternative liquidity ratios to the cash ratio?

    Learn what the cash ratio measures, and understand what two other liquidity ratios can be used by a company to replace the ... Read Answer >>
  3. What is the difference between the current ratio and the acid test ratio?

    Read about the main differences between the acid-test ratio and the current ratio, two measures of a company's liquidity ... Read Answer >>
  4. How can a company quickly increase its liquidity ratio?

    Discover what high and low values in the liquidity ratio mean and what steps companies can take to improve liquidity ratios ... Read Answer >>
  5. What are the main differences between the current ratio and the quick ratio?

    Find out how the quick ratio and the current ratio can offer different views on a company's ability to pay off liabilities. Read Answer >>
  6. Is liquidity calculated by flow?

    Read about the differences between economic liquidity, financial liquidity and asset liquidity and how each respective type ... Read Answer >>
Hot Definitions
  1. Physical Capital

    Physical capital is one of the three main factors of production in economic theory. It consists of manmade goods that assist ...
  2. Labor Market

    The labor market refers to the supply and demand for labor, in which employees provide the supply and employers the demand. ...
  3. Demand Curve

    The demand curve is a graphical representation of the relationship between the price of a good or service and the quantity ...
  4. Goldilocks Economy

    An economy that is not so hot that it causes inflation, and not so cold that it causes a recession. This term is used to ...
  5. White Squire

    Very similar to a "white knight", but instead of purchasing a majority interest, the squire purchases a lesser interest in ...
Trading Center