As an investor, it’s important to understand the difference between liquidity and illiquidity when making investment decisions.
This measurement also plays a vital role when setting your investment budget and analyzing risk. Additionally, lenders oftentimes assess the liquidity of your assets when approving personal and business loans.
What is liquidity?
As mentioned above, liquidity represents how fast you can convert an asset, such as stocks and bonds, into readily available cash. However, for an asset to be liquid, you must not only be able to quickly convert it into cash, but the asset must also maintain its basic market value throughout the conversion. The easier and faster you can convert an asset into cash without impacting its market price, the more liquid the asset is.
Lenders as well as investors often analyze a company’s liquidity ratio before approving any type of business loan or making an investment. The liquidity ratio determines the company’s ability to convert its assets into cash in comparison to its debt obligations. While what’s considered an acceptable liquidity ratio varies greatly, most lenders and investors are looking for companies with a ratio of at least one.
As an investor, understanding the liquidity of a specific asset can help you make investment decisions. For example, if you’re a new investor, you may want to consider more liquid assets that can be easily converted to cash if necessary. This can help reduce the risk factor until you're more comfortable with the investment process. Liquid assets can also provide a level of financial security in the event of a recession.
Most investors, however, prefer to build an investment portfolio that includes a combination of both liquid and illiquid assets. It’s important to understand that it may take longer to convert an illiquid asset into cash and you also may lose money on your investment by making this conversion too early.
Examples of liquidity
Cash, of course, is considered the most liquid of all assets. With cash, including your savings and checking accounts, no conversion is necessary. Rather, these funds are already fully available to you. The next type of liquid assets is cash alternative investments, such as CDs, treasury bills, and money market accounts.
For these assets, the liquidity of the investment ties into its terms. For example, you won’t reap the full benefits of your investment in a CD unless you hold it until the end of its term, which could be several months or years. Even though you may incur penalties for cashing these assets in before the end of the term, you can convert them into cash rather quickly, which makes them liquid assets.
Stocks and bonds are also considered liquid assets. However, the level of liquidity for these assets depends greatly on the type of stocks and bonds. For example, large-cap stocks are known for their high-trading volume, tight bid-ask spread and fast trade options. This combination makes these stock options highly liquid investments.
Other types of assets, such as real estate, art, collectibles, jewelry, and equipment are illiquid assets. These assets are more difficult to convert into cash because it takes more time to secure a buyer. Furthermore, if you need to sell them quickly, you’re likely to do so at a loss.
The two measures of liquidity
There are two primary ways to measure liquidity, market liquidity and accounting liquidity. Both methods of measuring liquidity are effective, but they serve very different purposes. Whether you’re an investor or business owner, it’s important to understand the difference between market and accounting liquidity.
Market liquidity
Market liquidity measures the efficiency of various markets to buy and sell assets. For example, you can measure a stock's liquidity by how easy it is to buy and sell the stock at a stable price in its respective market.
High-liquid markets allow assets to be sold, traded and bought quickly and without causing a significant drop in price value. Low-liquid markets are the exact opposite. In these markets, it can be difficult to sell and buy assets or to do so without incurring a significant drop in the price of the asset.
If you’re looking for investment options that you can easily convert into cash, it may be ideal to look for those in high liquid markets.
Accounting liquidity
Rather than measure market efficiency, accounting liquidity measures a company’s ability to pay off its short-term debts. This measurement compares the company’s current assets against its current liabilities to determine a liquidity ratio. This ratio often serves as a good indicator of the overall financial health of a company.
Naturally, companies use this measurement to assess their own financial health. However, investors and lenders also use accounting liability when making investment decisions or loan approvals. While there are no specific standards for identifying a good accounting liquidity ratio, investors should look for companies that have a minimum ratio of one.
How to measure liquidity
There are several techniques you can use to measure the liquidity of an organization. Below is a look at the four most common methods.
Current ratio
The current ratio technique for measuring liquidity is the easiest method available. It provides a quick overview of the company’s overall financial health. The formula is quite simple and uses data right from the company’s financial statements. This allows investors with limited company data to still measure the liquidity ratio prior to investing.
current liquid assets / current liabilities = current ratio
In this formula, current liquid assets and current liabilities are defined as those that can be turned into cash or are owed within 1-year period.
Quick ratio
The quick ratio method is similar to the current ratio, except it only includes the most liquid assets, such as cash and cash alternatives. This measurement evaluates how financially able the company is to pay off its current debt obligations.
quick assets / current liabilities = quick ratio
Quick assets in this formula include cash, cash alternatives, marketable securities, stocks, bonds and net account receivables.
Acid-test ratio
The acid-test ratio is often confused with the quick ratio. However, there is one major difference. The acid-test ratio removes inventories and prepaid costs from the equation. It also provides a more generous look at the company’s financial status. While this measurement technique serves many purposes, investors may want to use a more in-depth assessment method to obtain a clear view of the company’s financial health.
current assets – inventories – prepaid costs / current liabilities = acid-test ratio
Cash ratio
The cash ratio provides the most accurate view of the company’s financial health and its ability to meet its short-term debt obligations. It shows the company’s ability to repay its debt in emergency situations. A healthy cash ratio can keep the company from going under during extreme times. This formula removes all inventories, accounts receivable and all liquid assets, except for cash and cash equivalents.
cash + cash alternatives/ current liabilities = cash ratio
Are stocks liquid assets?
The liquidity of stocks varies greatly based on three primary factors, including its trading volume, bid-ask spread and the efficiency of its respective market. When comparing various stock investment options, it’s important to evaluate the stock’s liquidity by assessing these three factors.
Trading volume
Traditionally, stocks with a high-trading volume are the most liquid options. Since so many of these stocks are traded, bought and sold throughout the day, it’s usually easy to sell them and convert them to cash if necessary.
Bid-ask spread
You can also evaluate the liquidity of a stock by assessing its bid-ask spread. This spread represents the difference between the highest price a buyer is willing to purchase the stock for and the lowest price the seller is willing to sell it. A tighter bid-ask spread typically indicates higher liquidity, which means you likely can sell the stock quickly without a significant drop in its value. On the other hand, a wider spread often signifies less liquidity, which means you might realize a loss through a quick sale.
Trade process efficiency
Being able to sell your stock quickly when necessary also depends on the efficiency of the trading process in the market where you purchase the stock. The more efficient this trading process is, the more liquid the stock is. However, markets with complex and time-consuming trading processes can diminish a stock's liquidity.
Our take
Whether you’re a business owner or investor, it’s crucial to understand the meaning of liquidity and how the measure of liquidity can help you make sound investment decisions. Choosing highly liquid assets can allow you to make investments while maintaining peace of mind that you can quickly convert these assets into cash if necessary.
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