Liquidity In Finance

Ever looked at a newspaper headline and read ‘Company declares bankruptcy due to possession of illiquid assets!”, and wondered what it really means, or do you simply want some clarity on financial liquidity? Either way, your quest for those answers ends here. 

Liquidity translates to the financial liberty of operation. It can serve as a life-boat to those who need one. Furthermore, it is deemed pristine by every company, be it a Fortune500 company, or a start-up. Liquidity is something that every company, and individual, should possess.

It is that key that unlocks improved financial security, expanded financial planning, and most of all, a sounder peace of mind. In this article, we will cover what liquidity means, assets - what it means and its types, liquid market, liquidity ratios, and lastly its significance. 

Let us start by defining liquidity; the availability of liquid assets to a market, or a company. It suggests how quickly and easily you can convert an asset to cash whilst still maintaining its value. These liquid assets have proven to be handy when it comes down to payments of debts or bills. Often, companies have declared themselves insolvent or bankrupt as they were unable to clear their dues. To evade situations as such, liquid assets are necessary to have in your backyard.

Assets and its Types:

The term 'Asset' is defined as an item of property owned by a person or company, regarded as having value. Now, a financial asset works as a security blanket and so, is labeled as financial securities or financial instruments. If you think of pizza as an asset, then liquidity is the money you get from selling it. Now there is more than just one kind of pizza, there is Margherita, vegetables, chicken barbeque, and so on.

Similarly, there is more than just one type of asset - these are fixed assets, securities, and hard cash. Each of them is explained further below. Examples of assets are stocks, bonds, loans, bank deposits, and so on. The degree of liquidity of an asset is often associated with its value. The higher the degree of its liquidity, the higher is its value. 

Fixed assets, the most common example being real-estate, highlights the difficulty and increased efforts taken to sell it. Automobiles are also regarded as a fixed asset, or a less-liquid asset as it takes longer to sell. For instance, an icy, rock hard jug of frozen water. Now, even though the ice will eventually melt into water, the time and effort taken by it will be much more than plain liquid at room temperature. So, we call the jug of frozen water, a less-liquid asset.

Securities such as bonds and stocks are easily sellable. That being said, how promptly they sell differs based on the type of security you hold. Simply put, it is defined as any proof of ownership that has been designated a value, which when sold, yields money. They are broadly categorized into 1) debt securities - bonds, debentures, banknotes, and so on 2) derivatives - futures, forwards, options, etc. and 3) equity securities - stocks. 

Hard cash, like in a savings account or withdrawn from an ATM, is the most liquid asset. It maintains its value and requires no conversion. 

Liquid Market: This means that there are perpetually investors on the market that are prepared to exchange securities at any price level. It involves high trading activity. Transactions take place easily here. The most liquid market in the world is the forex market. Trading of foreign currency takes place here. Governed by the U.S. dollar, it is reckoned that the daily buying-selling volume in the currency market is over $5 trillion. 

Liquidity Ratios: Liquid asset, as mentioned earlier, is one that can easily be turned into cash. Although there is no specific formula to calculate liquidity, there are three popular measures: current ratio, quick ratio, and acid-test ratio.

  • Current Ratio is a liquidity ratio that estimates the capacity of a company or a firm to pay its short-term obligations. Obligations due within a year are also considered as short-term in the calculation of the current ratio. It may also be referred to as the ‘working capital’ ratio. It is calculated by dividing the current assets by current liabilities.  For instance, a current ratio of 3.6 would indicate that for every 1 dollar that the company owed its creditors, it is owed 3.6 by its debtors.
  • Quick Ratio intimates the short-term liquidity position of a firm. It is when the difference between current assets and inventory is divided by the current liabilities. The results of these ratios yield a direct relationship with liquidity. This intimates that the higher the result, the higher the liquidity. A firm having a quick ratio of less than 1 signifies its inability to repay its current liabilities.
  • The Acid-Test ratio represents the ability of a company to clear all its liabilities, without the use of inventory. It is measured by dividing the sum of cash, receivables, short-term investments by current liabilities. An acid-test ratio of 1 shows that the assets currently possessed today would exactly cover the liabilities that are due in the coming year.

The weight that liquidity holds is undeniable. It commands the financial health of a company. More importantly and simply put, it dictates the ease with which you can enter, or exit the market. For a budding entrepreneur, payment of bills in advance is crucial, and thus once again, liquid assets prove their worth. Furthermore, liquidity is important when considering your trading situations and the capacity to exit them. 

A thumb rule to keep in mind whilst investing in assets is to remember - diversification is key. Diversifying your assets potentially yields higher returns on investment. In a nutshell, liquidity serves as a safety-net and is an unquestionable must for not only companies but anybody looking to secure a brighter financial future. Ruth Porat says it best, "Liquidity is oxygen for a financial system". 


3 responses to “Liquidity In Finance”

  1. Natty says:

    Well put !
    Loved the examples to help understand the concept !
    Well done !

  2. Atool Sinha says:

    Wow, got to understand the concept of ‘Liquidity’ in an unambiguous manner… Well done, once again!! 😀

  3. Carol Levendal says:

    Very well explained. Gives you insight into your personal financial position at this point in time

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