What is Liquidity?
Liquidity Definition: the availability of liquid assets, usually cash, to a market or company.
The definition of liquidity tells us that in a liquid stock market, shares are easily exchanged, thereby supporting higher prices. In an illiquid market, shares are difficult to trade, thus pushing prices lower.
It may come as little surprise that cash is the most liquid asset, but other assets can also be highly liquid. Real estate, fine art and collectibles are among the asset classes with the highest liquidity, while other financial assets fall at various places on the liquidity spectrum.
How Liquidity Works
An asset or security will either be deemed liquid or illiquid. A liquid asset can be converted into cash quickly without impacting the market price. An Illiquid asset is difficult to convert into cash quickly without a substantial loss in value.
Investors generally favor liquid assets as they come with less risk. Illiquid assets can be harder to sell and increase the risk of losses. But assets with high liquidity are usually easier to sell for their full value while incurring little to no cost.
The factors determining whether an asset is liquid or illiquid include the level of interest from various market actors and the daily transaction volume. For example, the stock of a large multinational bank will typically be more liquid than that of a small regional bank.
Companies generally hold enough liquid assets to cover short-term obligations such as bills or payroll.
The two main measures of liquidity are market liquidity and accounting liquidity. Market liquidity relates to the extent to which a market, such as a stock market, allows assets to be bought and sold at stable and transparent prices.
In a highly liquid market, the price a buyer offers per share and the price the seller is willing to accept will usually be close. However, these two prices may vary significantly in an illiquid market, with the seller suffering significant losses.
Accounting liquidity measures the ease with which a company can meet its short-term financial obligations with the liquid assets they have available to them. Accounting liquidity is the company’s ability to pay its debts as they become due.
There are several liquidity ratios used to measure a company’s ability to pay off its short-term liabilities. A higher liquidity ratio means the company can quickly sell off its assets to pay off its debts, while a lower liquidity ratio could serve as a warning that the company may be at risk of default.
Financial analysts use a variety of ratios, including current ratio, quick ratio, cash ratio and acid-test ratio, to identify companies with strong liquidity. Accounting liquidity is also considered a measure of market depth.
The Current Ratio is a short-term liquidity ratio. It measures whether a company can afford to pay its bills. To calculate the Current Ratio, Current Assets are divided by Current Liabilities.
The Quick Ratio provides a short-term picture of how liquid a company is. To calculate the Quick Ratio, Quick Assets are divided by Quick Liabilities. This means assets that can be converted to cash quickly, including cash, marketable securities, short-term cash convertible investments and trade receivables.
The advantages of liquidity include:
Having a portfolio of highly liquid assets can act as a safety net in the scenario of an unexpected event. Whether an economic change or a change to your personal circumstances, liquid assets can provide security. When it comes to stocks, large-cap companies, which are considered low-risk investments, tend to have high liquidity, while micro-cap stocks with higher risk attached tend to come with low liquidity.
Greater Buying Power
Liquidity delivers greater financial freedom and buying power. Liquid assets provide investors or companies with immediate access to cash for small or large purchases. Having this access means individuals can act on opportunities that may otherwise be unavailable to them.
Disadvantages of Liquidity
The disadvantages of liquidity include:
If inflation rises, the cost of goods can jump dramatically, which could mean that the cash you have gained from selling your liquid assets is worth less than when you first invested it. Although it may be the same sum of money, it will now have less buying power.
Lack of Pricing Flexibility
Liquid assets are worth what they’re worth. There is little room for negotiation or selling your liquid assets for more than their market value. While liquid assets provide greater security, they may not offer a great return.
What is a Liquidity Trap?
In a very low-interest rate environment, there is the risk of a liquidity trap. This means people would rather store cash than risk holding a financial instrument with a low yield (bonds or dividend stocks).
A liquidity trap is a macroeconomic scenario in which cash is preferable because it is highly liquid. Bonds come with an agreed term, so selling early to access the cash could incur a loss. The same goes for stocks. For instance, in a deflationary environment, the stock may lose its liquidity and, thus, its value.
A liquidity trap is also a concern after a major economic incident, such as a great depression or financial crisis. At this point, people are scared of risk and prefer the security of cash.
The most well-known example of a recent liquidity trap occurred in Japan. The Japanese economy suffered through a period of prolonged stagnation, despite near-zero interest rates.
What is a Liquidity Event?
A liquidity event is a transaction or series of transactions that result in a large influx of cash for a company or individual.
Last updated: December 5, 2022