Liquidity is the availability of cash or cash equivalents to meet short-term operational requirements. Liquidity refers to the number of liquid assets that are available to pay expenditures and debts as they become payable.
Cash is the most liquid asset, other tangible assets such as real estate, fine art and collectables are fairly illiquid. Other financial assets, ranging from equities to partnership units fall at various places on the liquidity spectrum. Before investing a company needs to look at its liquidity.
What does Liquidity Mean?
Liquidity ratios are often used to determine how well a business is performing. Creditors are mainly concerned with a company’s ability to pay its debts; they want to know that the company will have enough cash or cash equivalents to meet its current obligation.
Investors are concerned with the overall health of the business and how it can increase its performance in the future. Companies that struggle with liquidity typically have a difficult time growing and increasing performance because there are no short-term funds available. Poor liquidity is also a sign that the company fails to proficiently create profits with its assets to meet its current obligations.
Creditors and investors prefer higher liquidity levels, but enormously high levels of liquidity could mean the company isn’t properly investing its funds. If for example, the cash represents 90% of a business asset, investors might speculate why these resources aren’t being used to grow the operations and invest in new capital. Creditors wouldn’t care much because they just want to make sure there is sufficient money to pay back any loans.
Let’s look at the difference between market liquidity and accounting liquidity.
Market Liquidity
Market liquidity is how a country’s stock market, or any other market, permits you to buy and sell assets at a steady, transparent price. Stock markets are normally characterized by higher market liquidity. If an exchange has a high volume of trade that is not dominated by selling, the price a buyer bids per share and the price that the seller is prepared to take will be close to each other. If the spread between the offer and the asking price grows the market becomes more illiquid.
Accounting Liquidity
Accounting liquidity is the effortlessness of which a company can meet its financial obligations with the liquid assets available. There are different ratios to measure accounting liquidity.
Liquidity Ratios
Current Ratio
The current ratio measures the current assets against the current liabilities.
$$Current\: Ratio = \dfrac{Current\: Assets}{Current\: Liabilities}$$
Acid Test/Quick Ratio
Acid-Test/Quick ratio includes the inventory and other current assets which are not liquid such as cash and cash equivalents, account receivable and short-term investments.
$$Quick\: Ratio = \dfrac{Cash + Cash\: Equivalents + Short\: Term\: Investments + Current\: Receivables}{Current\: Liabilities}$$
A variation of the acid-test/quick ratio simply subtracts inventory from the current assets, making it a bit more generous.
$$\text{Acid-Test Ratio} = \dfrac{Current\: Assets - Inventories - Prepaid\: Costs}{Current\: Liabilities}$$
Cash Ratio
The cash ratio defines liquid assets as only cash and cash equivalents. It assesses the company’s ability to handle an emergency.
$$Cash\: Ratio = \dfrac{Cash + Cash\: Equivalents + Short-Term\: Investments}{Total\: Current\: Liabilities}$$
Working Capital Ratio
The working capital ratio is a liquidity tool that gauges a company’s ability to settle its current debts with its current assets. Current assets are listed in the order of liquidity meaning the most liquid assets will be listed first in the balance sheet.
$$Working\: Capital\: Ratio = \dfrac{Current\: Assets}{Current\: Liabilities}$$
Example of Liquidity
Equities are some of the most liquid investment assets but not all equities are equal when it comes to liquidity. Some shares will attract greater more consistent interest from investors making them more active. Liquid stocks are normally identified by their daily volume.
Jacky wants to buy a $500 dishwasher; cash would be the asset that would be the easiest to obtain to purchase the dishwasher. Jacky is unable to get the $500 in cash, but she has a rare Harry Potter wizard collection that is valued at $500.
Jacky is willing to sell her collection and use the money to purchase the dishwasher. It is however not easy to sell the collection and she could thus wait for a long time or sell the collection at a discount. Jacky’s collection will be considered an illiquid asset.
Liquidity Conclusion
- Liquidity refers to the number of liquid assets that are available to pay expenses and debts as they become due.
- 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.
- The different liquidity ratios are current ratio, acid-test ratio and cash ratio.