What Is Liquidity?
Cash is universally considered the most liquid asset, while 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.
Why Is Liquidity Important?
The Basics of 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 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/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.
- Liquidity reflects whether there is a ready market for an asset—the ease of converting it to cash.
- Cash is the most liquid of assets; tangible items, among the less liquid.
- There are different ways to measure liquidity, including market liquidity and accounting 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 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.
Measuring Accounting Liquidity
Generally, in using these formulas, a ratio greater than one is desirable.
Current Ratio = Current Assets / Current Liabilities
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. As a formula:
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 - Prepaid Costs) / Current Liabilities
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:
Cash Ratio = (Cash and Cash Equivalents + Short-Term Investments) / Current Liabilities
Real World Example of Liquidity
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—they attract greater, more consistent interest from traders and investors, in other words. These liquid stocks are usually identifiable by their daily volume, which can number millions of shares, or even hundreds of millions.
For example, on April 26, 2019, 8.2 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 71.5 million shares—or to Ford Motor (F), which led the New York Stock Exchange with a volume of 154.8 million shares, making it the most liquid stock in the U.S. that day.