WHAT IS LIQUIDITY? LIQUIDITY REFERS TO THE QUICKNESS AND EASE TO BUY OR SELL AN ASSET – BASICALLY, TURNING IT INTO CASH, WITHOUT AFFECTING THE PRICE.
What is Liquidity? Definition of Liquidity, Liquidity Meaning
What is liquidity? Liquidity is how easy it is to buy or liquidate an investment asset – or an asset that you can convert quickly for a fair price. Stocks and bonds are liquid assets, while real estate and equipment are not.
Considering the liquidity of investment assets is very important if you want to buy or sell them in a short time. Companies need to have a certain level of liquidity to meet short-term financial obligations, such as future bills. On the other hand, Solvency refers to a company’s ability to pay its long-term debts. There are several different formulas for assessing a company’s liquidity.
Stocks have varying degrees of liquidity. Large-cap stocks (typical companies with a market value of at least $10 billion) are usually more liquid than small-cap stocks (typical companies with a market value of between $250 million and $2 billion).
That’s because there are more buyers and sellers for large-cap stocks. For example, Apple is a very liquid stock – you can buy or resell it quickly at market prices. A large volume of Apple stock is traded daily (over 25 million on average), making it easier to find a buyer or seller. If you want to buy or sell a stock with a lower trading volume, like Freddie Mac, then this can take longer. As a result, the stock is considered less liquid.
Find out more
- What is Liquidity?
- What is meant by market liquidity?
- What is Accounting Liquidity?
- What Are Liquid Assets?
- How to Measure Liquidity?
What is Liquidity?
Liquidity refers to how quickly you can buy or sell an asset – turning it into cash – without affecting its price. Assets have varying degrees of liquidity. Cash is the most liquid asset because you can turn it into other assets quickly and easily.
To illustrate this, let’s say you want to buy a car for $10,000. You don’t have $10,000 in cash, but you do have a painting worth that amount. To get $10,000 in cash, you have to sell the painting. But you may have to sell it at a discount if you need cash urgently or you can’t find a buyer willing to pay the price you want. So, painting is not a liquid asset.
What is Market Liquidity?
In the world of economics or investment, Market liquidity refers to how quickly an asset can be sold without changing its price too much or incurring high costs. The sooner you buy or sell an investment, the more liquid it is.
Higher market liquidity means more buyers and sellers, so transactions can run smoothly. Market liquidity is very important because buying or selling your assets when you want them, allows you to make a profit, avoid losses, or adapt to your changing needs or market context.
In less liquid markets, there are fewer buyers and sellers making it more difficult to complete transactions. You risk getting stuck with your investment or you won’t be able to sell it at the desired price increase.
In addition, the bid-ask spread is larger than in illiquid markets. The bid-ask spread is the difference between the highest price buyers are ready to pay and the lowest price sellers are willing to sell. Since investors cannot sell illiquid investments whenever they want, they will usually demand higher returns to compensate them for taking on higher risk.
What is Accounting Liquidity?
Accounting liquidity refers to a company’s ability to pay off current liabilities (debt) with existing current assets.
Current assets are assets that are expected to be turned into cash within one year. The most common are cash, marketable securities (such as stocks and bonds), inventory, and accounts receivable (money a company must pay for goods or services it has provided).
Current liabilities are liabilities that are expected to be repaid in less than one year. This includes accounts payable (the company’s debts to creditors and suppliers in the short term), accrued expenses (expenses already incurred but not yet paid), and deferred revenue (payments received in advance for products or services that have not yet been delivered). Companies report assets on their balance sheets, usually listed from the most liquid to the least liquid. Cash is in the first place, while assets such as property and equipment are at the bottom.
Solvency is almost the same as liquidity, which is a way to measure a company’s financial health. The difference is that liquidity is a short-term concept, whereas solvency takes a long-term perspective. Solvency measures a company’s cash flow relative to all of its liabilities, not just short-term debt.
Highly solvent companies are likely to continue operating for a long time in the future. Companies can be very solvent but have low liquidity and vice versa. In order to remain competitive, companies generally need to be liquid and solvent.
Also Read: What Do Hawkish and Dovish Mean?
What are Liquid Assets?
Liquid assets are easy to convert into cash quickly without changing their value significantly. Generally, liquid assets are traded in an established market with a large number of buyers and sellers, such as large exchanges. Cash is the most liquid asset because you don’t have to sell or convert it – Cash is ready to go.
Securities such as stocks and bonds are usually very liquid. You can convert it to cash in just a few days, depending on the size of the investment. Treasury bills (debt obligations issued by the US government with maturities of one year or less) and money market mutual funds are some of the most liquid debt securities.
Exchange-traded funds (ETFs), which are investment funds traded on a stock exchange, are typically more liquid than mutual funds (investment funds that are managed by raising money from investors to buy securities) because they trade like stocks.
Illiquid assets are more difficult to convert to cash and may lose a lot of value in the process. Real estate is an illiquid asset because it can be difficult for you to sell the property quickly. There may also be a significant difference between the paper value of the property and the actual amount you would earn for the property.
Private arts and businesses are also illiquid assets, as they can take months or years to sell. Many hedge funds also impose limits on the withdrawal of funds you contribute, making it an illiquid investment.
In business, liquidity is one of the important factors that determine success. Companies that have sufficient liquid assets will be able to meet their direct financial obligations and operating costs, such as salaries and supplier fees. Lack of liquidity will force companies to sell assets they don’t want to lose. In the worst case, a company can end up in bankruptcy or close.
For individuals, it is very important to have liquid assets to pay for day-to-day expenses and deal with emergencies. If you don’t have cash, you may be forced to take out a loan with a high interest rate when your car breaks down or a medical bill comes up unexpectedly. Retirees may prefer to have liquid investments so that they can earn income from their investment portfolio.
How to Measure Liquidity?
Instead of calculating the liquidity of individual assets directly, business and analysis using financial ratios is better for assessing the company’s overall liquidity level. The liquidity ratio shows the company’s ability to convert assets into cash to pay off short-term debt. Here are the four main ratios used:
Current Ratio (working capital ratio): It measures the company’s ability to pay off short-term debt (which matures in a year) with current assets (cash or things that can turn into cash in a year). Current Ratio 1 shows that the company is only able to meet all of its short-term obligations.
To understand liquidity, try to imagine water…
Water is a ready-to-drink liquid – you don’t have to turn it into something else first. But you also can’t drink ice cubes directly. Of course, you have to wait until the ice cubes melt and turn into water. Likewise liquidity, you can immediately use cash to buy goods. But if what you have is a house, then you have to sell it first to get cash.
It takes time, just as ice cubes take time to melt into something drinkable.