What is liquidity in financial markets?
Liquidity is a term you hear often in all financial markets regardless of the class of assets you follow. The term has to do with your ability to exit investments when the need arises. It’s also a measure of a company’s financial stability.
But what exactly is liquidity, how do you measure it, and why are investors infatuated with it? Read on to find out!
What Is Liquidity?
Liquidity is a measure of how easy it is to convert an asset to cash without changes in the market price.
For example, gold is a highly liquid asset because it can be quickly converted to cash at a fair market price. On the other hand, a piece of real estate is far less liquid. Although a quality piece of real estate is a solid investment, it may take weeks, months, or even years to find the right buyer who’s willing to give you the fair market value when you decide to sell.
There’s another way to look at liquidity in the stock market too.
Investors and analysts use liquidity ratios to determine a company’s ability to cover its short-term obligations using liquid assets on its balance sheet. In this context, high liquidity means the company is more than capable of paying its debts, while less liquid companies could default if things don’t go as planned.
Types of Liquidity
There are three types of liquidity. Each provides unique insights you can use to improve your outcomes when working in financial markets. The three types of liquidity are:
An asset’s liquidity is a measure of how easy it is to sell an asset at a fair market value quickly. This is measured on an asset-by-asset basis, and it’s largely based on the trading volume of the asset.
For example, Apple (AAPL) is a well-known stock that trades on the Nasdaq, while OMNIQ (OMQS) is a lesser-known company that also trades on the Nasdaq. Apple’s stock trades hands more than 90 million times during the average trading session, while OMNIQ’s trading volume is only about 16,000 shares per session.
So, Apple’s stock is far more liquid than OMNIQ’s. This means if you own a sizable position of Apple stock, you’ll be able to unload your shares quickly without affecting market value. On the other hand, if you have a sizable position in OMNIQ stock, it would likely take several trading sessions to offload your shares without making a meaningful impact on the stock’s price.
Market liquidity is a measure of a market’s ability to facilitate transactions quickly and at a transparent price.
For example, the stock market has a higher level of market liquidity than the fine art market. Some stocks are more liquid than others, and some are downright illiquid, but chances are you’ll have an easier time selling shares of stock at a fair price than you will selling a piece of fine art.
Accounting liquidity refers to a company’s ability to pay its short-term debts using its current assets, or assets it can easily turn into cash over the course of the next year.
For example, say companies ABC and XYZ both have $50 million in short-term obligations. However, company ABC has $75 million in current assets, while company XYZ has $25 million in current assets. In this case, ABC has plenty of assets on hand to cover its debts, meaning its liquidity is in good shape.
On the other hand, company XYZ would have to raise money or restructure its debt if things were to go wrong because it doesn’t have enough assets to cover its obligations. So, from an accounting perspective, XYZ is an illiquid company.
How to Measure Liquidity
Each of the three types of liquidity in financial markets is measured in a different way. Here’s how you measure liquidity in finance:
How to Measure Asset Liquidity
An asset’s liquidity is measured by the number of times that asset trades hands over the course of a predetermined amount of time.
For example, a stock’s liquidity is measured by its average trading volume. Stocks that trade hands more in the average trading session are more liquid than those that trade hands less.
You can find trading volume data at Yahoo! Finance or similar sources of stock quotes. Just type the company’s name in the search bar and look for “Avg Volume” in the data beside the stock chart.
How to Measure Market Liquidity
Market liquidity is generally measured by comparing the prices sellers are asking (ask) to the prices buyers are willing to pay (bid) in what’s known as a bid-ask spread. In a high-liquidity market, the bid-ask spread is minimal, meaning the price a seller is willing to accept is generally very close to the price a buyer is willing to pay.
In low-liquidity markets, the bid-ask spread is wider, meaning buyers aren’t generally willing to pay the prices sellers are asking. As a result, sellers in low-liquidity markets must either sell their assets at a discount to make a sale move along quickly or wait weeks, months, or even years for a buyer to come along that’s willing to pay a fair market price.
How to Measure a Company’s Liquidity (Accounting Liquidity)
A company’s accounting liquidity is a measure of its ability to pay its financial obligations in short order using assets on its balance sheet. Investors and analysts use three liquidity ratios to determine a company’s accounting liquidity. In general, a value of 1 or above is perceived as positive. Those include:
The current ratio is the easiest way to measure a company’s accounting liquidity. It compares the company’s current assets to its current liabilities using the equation below:
Current Ratio = Current Assets ÷ Current Liabilities
Using the examples of company’s ABC and XYZ above, the equations look like this:
ABC’s Current Ratio= $75 Million ÷ $50 Million = 1.5
XYZ Current Ratio = $25 Million ÷ $50 Million = 0.5
A good current ratio is between 1.2 and 2. So, based on this data, ABC may be a good investment, but you would want to stay away from XYZ.
Quick Ratio (aka Acid-Test Ratio)
The quick ratio follows along the same lines as the current ratio but doesn’t include all current assets. This ratio only accounts for assets that are easily converted into cash at a fair market price within 90 days. Those assets include cash and cash equivalents, accounts receivables, and short-term investments. The formula for the ratio is as follows:
Quick Ratio = (Cash & Cash Equivalents + Accounts Receivables + Short-Term Investments) ÷ Current Liabilities
For example, let’s say company ABC has $20 million in cash and cash equivalents, $20 million in short-term investments, and $5 million in accounts receivables. The rest of its current assets would take more than 90 days to reasonably turn into cash. The company has $50 million in short-term obligations; in this case, the formula would look like this:
ABC Quick Ratio = ($20 Million + $20 Million + $5 Million) ÷ $50 Million = 0.9
In general, investors look for a quick ratio above 1. In this example, ABC’s ratio is a caution flag.
A company’s cash ratio is the most telling because it compares a company’s cash and cash equivalents to its debts. A company that can cover all its obligations with cash on hand is a highly liquid company from an accounting perspective.
This is a worst-case-scenario ratio that shows whether a company would have the cash flow to stay out of default territory if an expensive, unforeseen event were to take place.
Like in the examples above, say company ABC has $20 million in cash and cash equivalents and $50 million in short-term obligations. The cash ratio formula for ABC is as follows:
Cash Ratio = $20 Million ÷ $50 Million = 0.4
Investors usually look for a cash ratio of 1 or above. So, in this example, the 0.4 cash ratio suggests ABC could hit some financial hurdles ahead.
Why Liquidity Is Important
Liquidity is important for a couple of reasons:
- Your Ability to Exit. Both market liquidity and asset liquidity point to your ability to exit an investment when you decide it’s time to sell. This is an important consideration when you choose an investment. If you’re investing money you won’t need back for years, it’s OK to consider illiquid options. However, if you may need the money in the short term, you should only invest in the most liquid assets found in the most liquid markets.
- A Company’s Ability to Pay Debts. You don’t want to invest in a company that’s likely to go into bankruptcy. That’s how losses happen! You can avoid these landmines in the market by assessing a company’s financial health using liquidity ratios before making an investment.
Liquidity Frequently Asked Questions (FAQs)
What Are the Most Liquid Assets?
The most liquid asset in the world is cash itself. After all, everyone wants to get their hands on it. Outside of cash, other highly liquid assets include marketable securities — stocks and bonds that trade on public exchanges — money market account balances, savings account balances, and gold and other precious metals.
What Are the Best Measures of Liquidity in Stocks?
Stock liquidity is best measured by looking at two metrics: the bid-ask spread and the trading volume. Stocks with high average trading volume and a minimal bid-ask spread are among the most liquid on the market, while those with a low trading volume and wide bid-ask spread lack liquidity.
What Happens When Liquidity Is Low?
When liquidity is low, investors wanting to sell must either wait for the right buyer to come along to purchase their assets or sell their assets at a discount.
If liquidity stays too low for too long, current investors often become frustrated and the stock has a hard time attracting new investors, leading to declines.
Liquidity is one of the most important financial terms for investors because it shows how long it will take for you to get a fair price when exiting investments and gives you clues about the financial stability of the companies you’re interested in investing in.
High and low liquidity aren’t good or bad things. They’re both fitting for different investors, and you may be well suited to invest in a mix of both. The key is how long you plan on holding the investment.
If you plan on investing for the long run and don’t expect to need the money you invest for years to come, some low-liquidity options like wine and fine art offer exciting potential returns. However, if you might need your investment dollars back soon, it’s best to invest in high-liquidity assets like stocks, gold, and money market accounts.