What is Liquidity?
Why Is Liquidity Important?
In other words, liquidity describes the degree to which an asset can be quickly bought or sold in the market at a price reflecting its intrinsic value. Cash is universally considered the most liquid asset because it can most quickly and easily be converted into other assets. Tangible assets, such as real estate, fine art, and collectibles, are all relatively illiquid. Other financial assets, ranging from equities to partnership units, fall at various places on the liquidity spectrum.
For example, 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 is unlikely to find someone willing to trade them the refrigerator for their collection. Instead, she will have to sell the collection and use the cash to purchase the refrigerator. That may be fine if the person can wait for months or years to make the purchase, but it could present a problem if the person only had a few days. She 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.
There are two main measures of liquidity:
- 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, 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 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. The liquidity of markets for other assets, such as derivatives, contracts, currencies, or commodities, often depends on their size, and how many open exchanges exist for them to be traded on.
- Accounting Liquidity - Accounting liquidity measures the ease with which an individual or company can meet their financial obligations with the liquid assets available to them—the 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 investment 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." Analysts and investors use these to identify companies with strong liquidity. It is also considered a measure of depth.
- Liquidity refers to the ease with which an asset, or security, can be converted into ready cash without affecting its market price.
- Cash is the most liquid of assets while tangible items are less liquid and the two main types of liquidity include market liquidity and accounting liquidity.
- Current, quick, and cash ratios are most commonly used to measure liquidity.
Generally, in using these formulas, a ratio greater than one is desirable.
- Current Ratio - The current ratio is the simplest and 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
- Quick Ratio (Acid-test ratio) - The quick ratio, or acid-test 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. The formula is:
Quick Ratio = (Cash and Cash Equivalents + Short-Term Investments + Accounts Receivable) / Current Liabilities
- Acid-Test Ratio (Var) - 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 - Prepaid Costs) / 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, it defines liquid assets strictly as cash or cash equivalents. More than the current ratio or acid-test ratio, it assesses an entity's ability to stay solvent in the case of an emergency—the worst-case scenario—on the grounds that even highly profitable companies can run into trouble if they do not have the liquidity to react to unforeseen events. Its formula is:
Cash Ratio = (Cash and Cash Equivalents + Short-Term Investments) / Current Liabilities
In terms of investments, equities as a class are among the most liquid assets. But not all equities are created equal when it comes to liquidity. Some shares trade more actively than others on stock exchanges, meaning there is more of a market for them. In other words, they attract greater, more consistent interest from traders and investors. These liquid stocks are usually identifiable by their daily volume, which can be in the millions, or even hundreds of millions, of shares.
For example, on April 26, 2019, 8.3 million shares of Amazon.com (AMZN) traded on the NASDAQ. Liquid as that sounds, it's not a drop in the bucket compared to Intel (INTC), which led the NASDAQ that day, with a volume of 72 million shares—or to Ford Motor (F), which led the New York Stock Exchange (NYSE) with a volume of 154.8 million shares, making it the most liquid stock in the U.S. that day.