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- Liquidity refers to how much cash is readily available, or how quickly something can be converted into cash.
- Market liquidity refers to how easy it is to sell an investment – how large and consistent the market for it is.
- Accounting liquidity refers to the amount of cash a company has on hand; investors use it to gauge a company's financial health.
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What is liquidity?
Liquidity can take on a different meaning depending on the context, but it always has to do with one thing: cash or cash. Liquidity refers to how quickly and easily a financial asset or security can be converted into cash without losing significant value. In other words, how long it takes to sell.
Liquidity is important because it shows how flexible a company is when it comes to meeting its financial obligations and unexpected costs. This also applies to the average person. The bigger theirliquid assets(save cashIninvestment portfolio) compared to their debts, the better their financial situation.
Types of liquidity
Liquidity takes two basic forms: market liquidity, which applies to investments and assets, and accounting liquidity, which applies to business or personal finance.
Liquidity of the market
Market liquidity is the liquidity of an asset and how quickly it can be converted into cash. In fact, how tradable it is, at prices that are stable and transparent.
High market liquidity means that there is a high supply and high demand for an asset, and there will always be sellers and buyers for that asset. If someone wants to sell an asset, but there is no one to buy it, then it may be illiquid.
Liquidity is not the same as profitability. For example, shares in a listed company are liquid: they can be sold quickly on the stock exchange, even if they have fallen in value. There will always be someone who wants to buy them.
When investing, it is important that an investor takes into account the liquidity of a particular asset or security. Among investments and financial instruments, the most liquid assets include:
- Savings/money market accounts
- Shares traded on major stock exchangesand exchange traded funds
- US government bonds
- Advertising sheet
- Other short-term money market securities
These can all be quickly sold at their fair value in exchange for cash.
Examples of illiquid assets, or assets that cannot be quickly converted into cash, are often tangible assets, such as real estate and art. This also includes securities traded on foreign exchanges, orcent shares, die over-the-counter handelt.
These items all take a long time to sell.
Accounting liquidity
Accounting liquidity is the ability of a company or individual to meet its financial obligations, including the money it owes on an ongoing basis.
For individuals, determining liquidity is a matter of comparing their debts to the amount of cash they have in the bank or the marketable securities in their investment accounts.
For companies it becomes a little more complex. Liquidity looks at a company's current assets in relation to its current liabilities.
How to measure a company's liquidity
Three liquidity ratios are primarily used to measure a company's accounting liquidity:
- Current relationship
- Fast relationship
- Cash-ratio
How current ratios are calculated
The current ratio is calculated as Current Ratio = Current assets/current liabilities. It is also known as the working capital ratio and its purpose is to determine a company's ability to meet its short-term obligations due within a year. The higher the ratio, the better a company's financial health and the stronger its ability to meet its financial obligations.
For example, if a company has current assets of $3 million and current liabilities of $2 million, it will have a current ratio of 3/2 = 1.5. If it now has current assets of $8 million and current liabilities remain $2 million, then it will have a current ratio of 8/2 = 4.
How quickly ratios are calculated
There are actually two formulas for the quick ratio: Quick Ratio = (cash + marketable securities + accounts receivable) / current liabilities, or Quick Ratio = (current assets - inventory - prepaid expenses) / current liabilities. The quick ratio, also called the acid test ratio, measures current assets to current liabilities.
When calculating current assets, it uses only the most liquid assets: cash, marketable securities and receivables. It does not include inventory, which is the case with the current ratio, because the inventory cannot be sold as quickly as the other assets.
Here too, the higher the ratio, the better a company is able to meet its financial obligations.
How to calculate cash ratio
The cash ratio is calculated as Cash Ratio = Liquidity/Short Term Debt. The cash ratio is an even stricter ratio than the quick ratio. It compareswhencash for short-term liabilities.
If a company can meet its financial obligations through cash alone without having to sell other assets, it is in an extremely strong financial position.
This is how liquidity works
A company's liquidity can be a key factor when deciding whether to invest in stocks or buy corporate bonds.
High liquidity ratios indicate that a company has a strong financial foundation to pay off its debt. Low liquidity ratios indicate that a company is more likely to default on its debt, especially if there is a downturn in the specific market or in the economy as a whole.
Regardless of the ratio you use:
- A value of 1 indicates that a company has current assets equal to current liabilities.
- A value above 1 indicates that a company has more current assets than current liabilities.
- A value less than 1 indicates that a company has more current liabilities than current assets and is unable to meet its financial obligations.
For the cash ratio, the values will only refer to cash, as opposed to all current assets.
When comparing liquidity ratios, it is important to only compare companies within the same sector. This is because each type of industry has different asset and liability requirements.
For example, a technology company does not operate in the same way as an airline. The technology company may need to buy computers and office space, while an airline needs to buy planes, many employees and jet fuel. So it is normal for an airline to have higher debt.
Reports from financial analysts on companies often include liquidity ratios. Otherwise, an investor may have to calculate this themselves using the information in a company's accounts or annual report.
The bottom line about liquidity
Liquidity refers to the amount of money a person or company has on hand and the ability to quickly convert assets into cash. The higher the liquidity, the easier it is to meet financial obligations, regardless of whether you are a company or an individual.
If someone has more savings than debts, it means they are more financially liquid.
Companies with higher levels of cash and assets that can be easily converted into cash indicate a strong financial position, as they have the ability to cover their debts and expenses and are therefore better investments.
The liquidity of a particular investment is important because it indicates the level of supply and demand for that security or asset – and how quickly it can be sold for cash if the need arises.
Ali Hussein
Ali Hussain worked in credit risk management and analyzed the risk factors of hedge fund trading. He started his career at Deutsche Bank and worked at other major financial institutions such as Citigroup, Bear Stearns and Societe Generale. After working in risk management for a few years, Ali moved to the front office where he worked in Sales & Trading, where he ran the sales side of the futures clearing business. Ali completed her master's degree in journalism at Columbia University, wrote about a variety of topics in school, and then began a freelance career after graduating. In addition to Insider, Ali has written for several publications, including the Huffington Post and Narrative.
