Liquidity is a measure used by investors and financial analysts to determine the ease or difficulty with which an asset or security can be converted into ready cash without affecting its market price.
It may come as little surprise that cash itself is the most liquid asset, but other assets can also be highly liquid. Real estate, fine art and collectables 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 as liquid or illiquid. A liquid asset is one that can be converted into ready cash quickly and with no impact on the market price. An Illiquid asset is one that 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 with small costs.
The factors that determine 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 multi-national bank will typically be more liquid than that of a small regional bank.
Companies will generally hold enough liquid assets to cover their short-term obligations such as bills or payroll.
Types of liquidity
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 high liquidity market, the price a buyer offers per share price and the price the seller is willing to accept will usually be fairly close. However, in an illiquid market, these two prices may vary greatly with the seller suffering significant losses.
Accounting liquidity measures the ease in which a company can meet their short-term financial obligations with the liquid assets they have available to them. Essentially, accounting liquidity is the company’s ability to pay its debts as they become due.
Financial analysts use a variety of ratios including current ratio, cash ratio and acid-test ratio to identify companies with strong liquidity. Accounting liquidity is also considered a measure of depth.
Advantages of liquidity
The advantages of liquidity include:
Having a portfolio of high liquidity 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.
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 not be available to them.
Disadvantages of liquidity
The disadvantages of liquidity include:
Vulnerable to inflation
If inflation rises, the cost of goods can jump dramatically, which could mean that the cash you have gained from the sale of 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 flexibility in price
Liquid assets are worth what they’re worth, there is little room for negotiations or selling your liquid assets for more than their market value. While they provide greater security, they may not provide a great return.