Liquidity refers to how easily an asset can be converted into cash in a short time frame without losing value. It is mainly measured by using current, quick, cash, and variable ratios. The most liquid asset is cash, followed by cash-equivalents. These can include CDs, bonds, and stocks. Tangible assets tend to be less liquid. An example of a tangible asset that is less liquid would be real estate.
Why Is Liquidity Important?
It is important because it can show how quickly a company can pay off its debt and short-term liabilities. Let’s review the types of liquidity below.
Types of Liquidity
There are several types including market, bid-ask spread, and accounting.
This form refers to the degree of which assets are able to be bought and sold at current prices, with little change to the original value of the asset. The stock market is an example of high market liquidity, where as real estate is usually less liquid.
Bid-ask spread is the difference between what a buyer is offering (bid price) and what a seller is willing to accept (ask price). Bid-ask spread can essentially represent supply and demand. It is the main measure of liquidity. If the bid-ask spread is narrow it will typically have a higher demand. Inversely, if the bid-ask spread is large, the demand will typically be lower.
This refers to how easy it is for an individual or company to use their liquid assets to pay off their debts when they are due. A company should strive for strong liquidity. Their liquid assets should positively compare with their current liabilities.
How To Calculate Liquidity
Analysts will measure a company’s liquidity by looking to see if their liquid assets can cover their short-term financial obligations. There are several formulas that can be used to measure it.
Current ratio, simply put, measures current assets against current liabilities. This is the easiest way to measure liquidity. The formula used to calculate current ratio is:
Current Ratio = Current Assets / Current Liabilities
Quick ratio is more strict than the current ratio. It can be used to show a company’s short-term liquidity. Also, it is referred to as the acid test ratio, as it is expected to show quick results. The formula used to calculate quick ratio is:
Quick Ratio = (Cash + Cash Equivalents + Marketable Securities + Accounts Receivable)/ Current Liabilities
A more simple and less strict variation of the quick ratio is:
Quick Ratio = (Current Assets – Inventory) / Current Liabilities
Cash ratio is used to simply define liquid assets as cash or cash equivalents. This is used as a worse-case scenario for companies to use on an emergent basis, should they run into trouble. The formula used to calculate cash ratio is:
Cash Ratio = (Cash + Marketable Securities) / Current Liabilities
Example of Liquidity
Looking at the formulas listed above, it’s easy to see that a company or individual should ensure that they have enough cash, cash equivalents, or current assets to cover their current liabilities.
Let’s say an individual has $5,000 in cash in their savings account. Also, let’s assume that individual has $10,000 in liquid assets available. If their total monthly liabilities equal $2,500, they would be able to cover their monthly liabilities for several months to come.
However, if they only had $1,000 in cash and $1,000 in liquid assets available, they wouldn’t be able to cover their monthly liabilities. In conclusion, companies or individuals can run into trouble if they do not have the liquidity available to cover unforeseen circumstances.
What Does Liquidity Tell Investors?
It is important because it can assist investors with deciding which companies they should invest in. Generally, if there is a lot of interest in a company’s stock they have a high liquidity.
Likewise, if a company is less known and has little interest in its stock, it will have low liquidity. It’s important to understand what high and low ratios mean.
High Liquidity Ratio
High ratios usually show that a company is doing well and is able to pay its debt. A high ratio is usually indicated by a number greater than 1. The higher the ratio, the more likely it is that a business or company can cover its liabilities.
Low Liquidity Ratio
Low ratio is represented by a number less than 1. This usually shows that a company will struggle to cover or cannot pay off their short-term obligations. This can also show financial struggle within a company.
Is Liquidity Good or Bad?
It can be either good or bad. Obviously, it will be more favorable to investors to see high versus low liquidity. However, too much liquidity can also be a red flag to investors.
Why Is Too Much Liquidity Bad?
In short, too much liquidity can mean that a company is not properly investing. This can cause investors to question why the company’s ratio is so high. It’s important to note that liquidity should be compared between similar companies or industries in order to properly understand a company’s ratio.
What Happens When Liquidity Increases?
This is usually indicative of a company paying off their liabilities and cutting back on costs or an individual paying off their debt. Additionally, increasing liquidity can be indicative of financial health, especially if a company had a low ratio. In the economy, increasing liquidity can mean that people have more money to spend, which can lead to inflation.
Liquidity: How it Can Affect You
The liquidity of a company is important since it can help to show how financially healthy that company is. Additionally, it can show if a company is likely to experience financial difficulties. This can be an important factor when looking to invest.
A financial advisor can assist you with understanding the liquidity of a company that you plan on investing in. Financial advisors can also assist you with understanding and managing your personal liquidity.