What is Liquidity? 

Liquidity refers to how easily an asset or security can be converted into cash without significantly impacting its market price. Cash is the most liquid asset because it is already in its most convertible form. Thus, the availability of cash is crucial for the efficient movement of markets.

Highly liquid assets can be quickly and cost-effectively converted to cash, while less liquid assets may require more time and incur higher costs.

Key points:

• Liquidity measures how easily an asset or security can be turned into cash without affecting its market price.
• Cash is the most liquid asset, whereas tangible items are less liquid.
• Liquidity can be categorised into market liquidity and accounting liquidity.
• Common liquidity metrics include the current ratio, quick ratio, and cash ratio.

Understanding Liquidity

Put simply, liquidity measures how easily an asset can be swiftly purchased or sold in the market at a price that mirrors its true worth. Cash holds the title of the most liquid asset due to its rapid and seamless conversion into other assets. Meanwhile, tangible assets like real estate, fine art, and collectibles are notably less liquid. Different financial assets, spanning from stocks to partnership units, lie across a spectrum of liquidity levels.

There are two specific types of liquidity to look out for.

Market Liquidity

Market liquidity denotes the degree to which a market, be it the national stock market or a local property market, permits assets to be openly traded at consistent prices.

The stock market is also recognised for its higher market liquidity. When an exchange experiences substantial trade volume that isn’t predominantly driven by selling, the bid price (what a buyer offers per share) and the ask price (the price a seller is willing to accept) tend to closely align.

This scenario allows investors to avoid sacrificing potential gains for a swift sale. A narrow spread between bid and ask prices signifies higher market liquidity, while a widening spread indicates increased illiquidity. Generally, real estate markets are notably less liquid compared to stock markets. The liquidity of markets involving other assets, such as derivatives, contracts, currencies, or commodities, typically relies on their size and the number of active exchanges available for their trading.

Accounting Liquidity

Accounting liquidity evaluates how easily an individual or company can fulfil their financial commitments using the liquid assets they possess—essentially, the capability to promptly settle debts.

In investment language, evaluating accounting liquidity involves weighing liquid assets against immediate liabilities, which are financial obligations due within a year.

Various ratios gauge accounting liquidity, each with distinct definitions of what qualifies as liquid assets. Analysts and investors use these ratios to take note of companies with robust liquidity. It’s also regarded as a measure of financial resilience.

How to Measure Liquidity Ratios

Some ratios can be used to measure a business’ liquidity.

Here’s how to measure liquidity using four key ratios: the Current Ratio, Quick Ratio (Acid-Test Ratio), Acid-Test Ratio (variation), and Cash Ratio.

Current Ratio

The Current Ratio assesses a company’s ability to meet short-term obligations with its short-term assets. It is calculated as follows:

Current Ratio = Current Assets ÷ Current Liabilities

Current Assets cover cash, accounts receivables, inventory stock, and other assets that are set to be sold for cash or used up within one year.

Current Liabilities encompass obligations that are due within the same period.

A current ratio of one or higher is generally considered good because it means that current assets can cover current liabilities.

Quick Ratio (Acid-Test Ratio)

The Quick Ratio, also known as the Acid-Test Ratio, provides a more stringent evaluation of liquidity by excluding inventory from current assets. It is calculated as follows:

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

Inventory is excluded from current assets because it may take time to sell and convert into cash.

The Quick Ratio offers a more conservative assessment of liquidity since it considers only the most liquid assets.

Acid-Test Ratio (Variation)

The Acid-Test Ratio is another variation of the Quick Ratio, focusing on the most liquid assets. It is calculated as follows:

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

In this variation, only the most liquid assets, such as cash, marketable securities, and accounts receivable, are considered. This ratio provides a stricter view of a company’s ability to meet short-term obligations without relying on inventory.

Cash Ratio

The cash ratio stands out as the most stringent among liquidity ratios. It specifically defines liquid assets as cash or cash equivalents, excluding accounts receivable, inventories, and other current assets.

Compared to the current ratio or acid-test ratio, the cash ratio evaluates an entity’s capacity to maintain solvency during emergencies—the worst-case scenario. This approach acknowledges that even highly profitable companies may face challenges if they lack the liquidity to respond to unforeseen events. Its formula is:

Cash Ratio = Cash and Cash Equivalents ÷ Current Liabilities

Cash Equivalents are highly liquid, short-term investments that are easily convertible into cash, with a very low risk of changes in value.

The Cash Ratio is the most stringent measure of liquidity, as it assesses a company’s ability to meet short-term obligations with only its most liquid assets.

Each ratio provides a different perspective on liquidity, and businesses may use a combination of these ratios to make more informed financial decisions.

Examples of Liquidity

Retail

Retailers need sufficient cash on hand to maintain inventory levels and stock products that meet consumer demand. If they lack liquidity, they can miss opportunities to capitalise on peak sales seasons or trends.

Retailers must also manage their accounts receivable efficiently. If customers are slow to pay, it can strain cash flow and affect the business’ ability to meet its own obligations, such as rent, utilities, and supplier payments.

Finally, having liquidity allows retailers to respond to unforeseen challenges, such as economic downturns or unexpected costs like store repairs or safety measures in response to a global pandemic. Australian retail businesses, in particular, found that out the hard way, when the nationwide lockdown shuttered customer flow, prompting more focus on digital shopping services and safe delivery options.

Manufacturing

In the manufacturing industry, liquidity is crucial for operational efficiency. Manufacturers often have significant investments in fixed assets such as machinery and facilities, which can tie up capital. To maintain liquidity, manufacturers must balance investing in fixed assets with cash reserves and the ability to access short-term financing when needed.

Manufacturers must also consider the liquidity of their supply chain. If suppliers require payment in advance or have lengthy payment terms, it can affect the manufacturer’s ability to manage cash flow effectively. Having liquidity allows manufacturers to take advantage of bulk purchasing or negotiate favourable terms with suppliers.

Moreover, manufacturers may need liquidity to respond to changes in demand or market conditions, such as sudden spikes in orders or unexpected interruptions in the supply chain. The team at global insurance broker Marsh noted how companies that needed to keep running during the COVID-19 lockdowns were forced to invest heavily in protective gear to ensure worker safety; these range from facemasks and air purifiers to testing kits and vaccines. 

Technology

Tech companies often invest heavily in R&D to stay competitive and bring new products to market. To fund R&D initiatives, they must maintain ample liquidity.

Additionally, tech companies frequently face the challenge of scaling their operations rapidly. This might involve hiring more employees, expanding infrastructure, or acquiring new technology. Liquidity is critical to support these growth initiatives and ensure that the company can adapt to market changes. The Silicon Valley Bank also notes the importance of forecasting potential events and maintaining the necessary liquidity to see them through, like, say a SaaS firm suddenly losing a key account to a rival outfit.

The technology industry is also known for its acquisition activities. Liquidity is essential for making strategic acquisitions, as it allows companies to seize opportunities when they arise. 

FAQs

Why is liquidity important?

When markets lack liquidity, converting assets or securities into cash becomes challenging. Consider owning a rare family heirloom worth $150,000. If there’s no market demand for the item, its appraised value becomes irrelevant due to its extreme illiquidity. Selling such an item might even necessitate hiring an auction house to act as an intermediary, incurring time and expenses.

Meanwhile, liquid assets can be swiftly and easily sold close to their full value with minimal costs. Companies must also hold sufficient liquid assets to cover short-term obligations like bills or payroll; otherwise, they risk a finance crisis that could lead to bankruptcy.

What are the most liquid assets or securities?

Cash stands as the most liquid asset, followed by cash equivalents like money market accounts, certificates of deposit (CDs), or time deposits. Marketable securities such as stocks and exchange-listed bonds are often highly liquid and can be promptly sold via a broker. Gold coins or bars and select collectibles may also be easily sold for cash.

What are some illiquid assets or securities?

Over-the-counter trade securities like certain complex derivatives often lack liquidity. For individuals, assets like homes, time-shares, or cars are relatively illiquid, taking a long time to find a buyer, plus more for negotiations and payment, coupled with substantial broker fees (e.g., averaging five to seven per cent for real estate agents).

The most liquid stocks typically attract substantial interest from various market players and experience high daily transaction volumes. They also draw more market makers, leading to tighter bid-ask spreads and greater market depth.

Why are some stocks more liquid than others?

Illiquid stocks exhibit wider bid-ask spreads and less market depth. These stocks are often less recognised, have lower trading volumes, and tend to possess lower market value and volatility. Consequently, stocks from large multinational banks are generally more liquid than those from smaller regional banks.

Conclusion

Liquidity is a fundamental aspect of financial management that affects businesses across various industries in Australia. It ensures a company’s ability to cover short-term obligations, invest in growth and innovation, and respond to changing market conditions. By understanding the types of liquidity, calculating liquidity ratios, and recognising its importance in different industry contexts, businesses can make informed financial decisions that contribute to their long-term success.

DISCLAIMER: This article is for informational purposes only and the opinion of the author. BARTERCARD has no business relationships with any company or organisation mentioned.