What Is Liquidity?

When an asset can be efficiently converted into ready cash without affecting its market value, it is considered a liquid asset. The ability to convert it quickly and efficiently is called liquidity. Consequently, the availabilit♊y of cash to make such conversions is the biggest influence on whether a market can move efficiently.

The more liquid an asset is, the ea𓆉sier and more efficient it is to turn it back into cash. Less liquid assets take more time and may have ꦛa higher cost.

Understanding Liquidity

Liquidity describes the degree to which an asset can be quickly bought or sold in the market at a price reflecting its intrinsic value. 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, they are unlikely to find someone willing to trade the refrigerator for their collection. Instead, they will have to sell the collection and use the cash to purcဣhase 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 has only a few days. They may have to sell the books at a discount, instead of waiting for a buyer who is willing to pay the full value. Rare books are an example of an illiquid asset.

Market 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 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 that a buyer offers per share (the 澳洲幸运5官方开奖结果体彩网:bid price) and the price that the seller is willing to accept (the 澳洲幸运5官方开奖结果体彩网: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 tightens, 澳洲幸运5官方开奖结果体彩网:the market is more liquid; when ᩚᩚᩚᩚᩚᩚ⁤⁤⁤⁤ᩚ⁤⁤⁤⁤ᩚ⁤⁤⁤⁤ᩚ𒀱ᩚᩚᩚit grows, the market instead 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 comp🍎any 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 澳洲幸运5官方开奖结果体彩网:current liabilities, or financ♊ial obligations🅷 that come due within one year.

There are several ratios that measure accounting liquidity, which differ in how strictly theꦯy define liquid assets. Analysts and investors use these to identify companies with strong liquid𝔍ity. It is also considered a measure of depth.

Measuring Liquidity

Financial analysts look at a firm’s ability to use liquid assetsꦺ to co๊ver its short-term obligations. Generally, when using these formulas, a ratio greater than one is desirable.

Current Ratio

The 澳洲幸运5官方开奖结果体彩网:current ratio is the simplest and least strict. It measures 澳洲幸运5官方开奖结果体彩网:current assets (those that can reasonably be converted to cash in one year) 澳洲幸运5官方开奖结果体彩网:against current liabilities. Its formula would be:

Current Ratio = Current Assets ÷ Current Liabilities

Quick Ratio (Acid-Test Ratio)

The 澳洲幸运5官方开奖结果体彩网:quick ratio, or 澳洲幸运5官方开奖结果体彩网:acid-test ratio, is slightly more strict. It excludes inventories and other current assets, which are not as liquid as cash and 澳洲幸运5官方开奖结果体彩网:cash equivalents, accounts receivable, and 澳洲幸运5官方开奖结果体彩网:short-term investments. The formula is:

Quick Ratio = (Cash and Cash Equivalents + Short-Term Investments + Accounts Receivable) ÷ Current Liabilities

Acid-Test Ratio (Variation)

A variation of the quick/acid-✅test ratio simply subtracts inventory from current assets, making it a bit more generous:

Acid-Test Ratio (Variation) = (Current Assets - Inventories - Prepaid Costs) ÷ Current Liabilities

Cash Ratio

The 澳洲幸运5官方开奖结果体彩网:cash ratio is the most exacting of the liquidity ratios. Excluding accounts receivable, as well a🅷s inventories 🍒and other current assets, it defines liquid assets strictly as cash or cash equivalents.

More than the current ratio or acid-test ratio, the cash ratio assesses an entity’s ability to stay solvent in 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 ÷ Current Liabilities

Liquidity Example

In terms of investments, equities as a class are among the most liquid assets. However, not all equities or other fungible securities are created equal in terms of liquidity. Some 澳洲幸运5官方开奖结果🍬体彩网:options and stocks trade more actiಌvely than others on stock exchanges. More activity means that 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. When a stock has high volume, it means that there are a large number of buyers and sellers in the market, which makes it easier for investors to buy or sell the stock without significantly 𝔉affecting its price. On the other hand, low-volume stocks may be harder to buy or sell, as there may be fewer market participants and therefore less liquidity.

For example, on March 13, 2023, 69.6 million shares of Amazon.com Inc. (AMZN) traded on exchanges. By comparison, Intel Corp. (INTC) saw a volume of just 48.1 million shares, indicating it was somewhat less liquid. However, Ford Motor Co. (F) had a volume of 118.5 million shares, making it the most active and presumably the most liquid among these three stocks on that day.

The Bottom Line

Liquidity is the ease of converting an asset or security into cash. Other liquid assets include stocks, ꦺbonds, and other exchange-traded securities. Tangible items tend to be less liquid, meaning that it can take more time, effort, and cost to sell them (e.g., a home).

Market liquidity and accounting liquidity are two main classifications of liquidity🍸, and financial analysts use various ratios, such as the current ratio, quick ratio, acid-test ratio, and cash ratio, to measure it. Liquid assets are essential for individuals and firms, as they enable them to settle their short-term debts and obligations, thereby avoiding a liquidity 🙈crisis.