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 considered 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 highlighted below.

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, she or he is unlikely to find someone willing to trade them the refrigerator for their collection. Instead, she/he 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. She/he 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 an example of an illiquid asset.

Market Liquidity

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 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 usually far less liquid than stock markets.

Accounting Liquidity

For an entity such as a person or a company, accounting liquidity is a measure of ability to pay off debts as they come due. 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:

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, see "Liquidity Measurement Ratios."

RELATED TERMS
  1. Quick Liquidity Ratio

    Quick liquidity ratio is the total amount of a company’s quick ...
  2. Liquid Asset

    A liquid asset is an asset that can be turned into cash quickly ...
  3. Liquidity Ratios

    Liquidity ratios are a class of financial metrics used to determine ...
  4. Quick Ratio

    The quick ratio measures a company’s ability to meet its short-term ...
  5. Cash Asset Ratio

    The cash asset ratio is the current value of marketable securities ...
  6. Current Assets

    Current assets is a balance sheet item that represents the value ...
Related Articles
  1. Investing

    Financial Analysis: Solvency vs. Liquidity Ratios

    Solvency and liquidity are equally important for a company's financial health.
  2. Investing

    How to calculate the current ratio in Excel

    Understand the basics of the current ratio, including its use in assessing a company's liquidity and learn how it is calculated in Microsoft Excel.
  3. Investing

    Understanding Liquidity Risk

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

    Key Financial Ratios for Retail Companies

    Using the following liquidity, profitability and debt ratios, an investor can gather deeper knowledge of a retail company's short-term and long-term outlook.
  5. Investing

    6 Basic Financial Ratios And What They Reveal

    These formulas can help you pick better stocks for your portfolio once you learn how to use them.
  6. Investing

    Ratio Analysis

    Ratio analysis is the use of quantitative analysis of financial information in a company’s financial statements. The analysis is done by comparing line items in a company’s financial ...
  7. Managing Wealth

    When Introducing Illiquidity to Your Portfolio Makes Sense

    Find out when you should consider adding illiquid investments to your portfolio, such as real estate or locked-up investment funds.
  8. Investing

    ETF Liquidity: Why It Matters

    Lower levels of liquidity in exchange-traded funds make it harder to trade them profitably.
RELATED FAQS
  1. How is the acid test ratio calculated?

    The acid-test ratio, also known as the quick ratio, measures the liquidity of a company and is a more conservative measurement ... Read Answer >>
  2. 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 >>
  3. Is there a downside to having a high liquidity ratio?

    Find out why it might be disadvantageous for a company to have liquidity ratios that are too high, and learn how to find ... Read Answer >>
  4. Differences between liquidity and liquid assets

    Liquid assets can easily be converted into cash. Liquidity is the ability of a business to pay its debts using its liquid ... Read Answer >>
  5. What is liquidity management?

    Take a look at the different definitions of liquidity, and find out how investors and businesses attempt to reduce exposure ... Read Answer >>
  6. What investments are considered liquid assets?

    In this article, you'll learn what liquid assets are, what assets are considered liquid, and what investments are considered ... Read Answer >>
Trading Center