What Is Financial Liquidity?
Consider all of the assets you own. Some things you own such as your nicest shirt or food in your refrigerator might be able to sold quickly. Others such as a rare collectible coin or custom painting of your family may be a bit more difficult. The relative ease in which things can be bought or sold is referred to as liquidity.
Financial liquidity impacts individuals, companies, and financial markets. As each group attempts to buy and sell things, it's crucial to understand what financial liquidity is, how to measure it, and why it is important.
Key Takeaways
- Financial liquidity refers to how easilyassets can be convertedinto cash.
- Cash, public stock, inventory, and some receivables are considered more liquid as a company or individual can expect to convert these to cash in the short-term.
- Long-term fixed assets or private securities are harder to sell, making them illiquid.
- A company can gauge its liquidity by calculating its current ratio, quick ratio, or operating cash flow ratio.
- Liquidity is important as it indicates whether there will be the short-term inability to satisfy debts or make agreements whole.
Understanding FinancialLiquidity
Assets like stocks and bonds are very liquid since they can be converted to cash within days.However, largeassets such as property, plant, and equipment are not as easily converted to cash. For example, your checking account is liquid, but if you owned land and needed to sell it,it may take weeks or months to liquidate it, making itlessliquid.
Before investingin any asset, it's important to keep in mindthe asset'sliquidity levels since it couldbe difficult or taketime to convert back into cash. Of course, other than selling an asset, cash can be obtained by borrowing against an asset. For example, banks lend money to companies, taking the companies'assets as collateral to protect the bank fromdefault. The company receives cashbut must pay back the original loan amountplusinterest to the bank.
Financial Liquidity By Asset Class
Cash is the most liquid asset, and companies may also hold very short-term investments that are considered cash equivalents that are also extremely liquid. Companies often have other short-term receivables that may convert to cash quickly. Unsold inventory on hand is often converted to money during the normal course of operations. Companies may also have obligations due from customers they've issued a credit to.
Some investments are easily converted to cash like public stocks and bonds. Since stocks and bonds have public exchanges with continual pricing, they'reoften referred to as liquid assets.
Other investment assets that take longer to convert to cash might includepreferred or restricted shares, which usually have covenants dictating how and when they canbe sold. In addition, specific types of investments may not have robust markets or a large group of interested investors to acquire the investment. Consider private shares of stock that cannot easily be exchanged by logging into your online brokerage account.
Coins, stamps, art and other collectibles are less liquid than cash if the investor wants full value for the items. For example, if an investorwasto sell to another collector, theymight get full value if they wait for the right buyer. However, because of the specialized market for collectibles, it might take time to match the right buyer to the right seller.
Land, real estate,or buildings areconsidered among the least liquid assetsbecause it could take weeks or months to sell them. Fixed assets often entail a lengthy sale process inclusive of legal documents and reporting requirements. Compared to public stock that can often be sold in an instant, these types of assets simply take longer and are illiquid.
As of April 30, 2022, 12.7 million shares of Class A GameStop shares had been directly registered with the company's transfer agent. The act of directly registering shares through Computershare effectively reduced the liquidity of the company's stock as shares held by exchanges could not as easily be loaned out.
Liquidity in the Market
Market liquidity refers to a market's ability to allow assets to be bought and sold easily and quickly, such as a country's financial markets or real estate market.
The market for a stock is liquid if itsshares can be quickly bought and sold and the trade has little impact on the stock's price. Company stocks traded on the major exchanges are typically considered liquid.
If an exchange has a high volume of trade, the price a buyer offers per share (thebid price) and the price the seller is willing to accept (theask price) should be close to each other. In other words, the buyer wouldn'thave to pay more to buy the stock and would be able to liquidate iteasily.When thespreadbetween the bid and ask prices widens, the market becomes more illiquid.For illiquid stocks, the spread can be much wider, amounting to a few percentage points of the trading price.
The time of day is important too. If you're trading stocks or investments after hours, there may be fewer market participants. Also, if you're trading an overseas instrument like currencies, liquidity might be less for the euro during,for example, Asian trading hours. As a result, the bid-offer-spread might be much wider than had you traded the euro during European trading hours.
Financial Liquidity Measurements
Liquidity forcompanies typically refers to a company's ability to use its current assets to meet itscurrent or short-term liabilities. A company is also measured by the amount of cash it generates above and beyond its liabilities. The cash left over that a company has to expand its business and pay shareholders via dividends is referred to as cash flow.
Below are three commonratios used tomeasure a company's liquidity orhow well acompany can liquidate its assets to meet its current obligations.
Liquidity Ratios
The current ratio(also known as working capital ratio)measures the liquidity ofa company and is calculated by dividing itscurrent assets by itscurrent liabilities.The term current refers to short-term assets or liabilities that are consumed (assets) and paid off (liabilities) is less than one year.The current ratio isused to providea company's ability to pay back its liabilities (debt andaccounts payable) with its assets (cash,marketable securities, inventory, andaccounts receivable).Of course, industry standards vary, but a company should ideally have a ratio greater than 1, meaning they have morecurrent assets to current liabilities. However, it's important to compare ratios to similar companies within the same industry for an accurate comparison.
The quick ratio, sometimes called the acid-test ratio, is identical to the current ratio,exceptthe ratioexcludes inventory. Inventory is removed because it is the most difficult to convert to cash when compared to the other current assets likecash, short-term investments, andaccounts receivable. In other words, inventoryis not as liquid as the other current assets. A ratio value of greater than one is typicallyconsidered good from a liquidity standpoint, but this is industry dependent.
The operating cash flowratio measures how well current liabilities are covered by the cash flow generated from a company's operations.The operating cash flowratio is ameasure ofshort-term liquiditybycalculating the number of times a company can pay down itscurrent debts with cash generated in the same period. The ratio is calculated by dividing the operating cash flow by the current liabilities.A higher number is better since it means a company can cover its current liabilitiesmore times.An increasing operating cash flow ratio is a sign offinancial health,while those companies with declining ratios may have liquidity issues in the short-term.
Liquidity is the measurement of short-term financial health, while solvency is the measurement of long-term financial health.
Why Is Liquidity Important?
In general, it's advantageous to hold assets that are liquid. These types of assets or investments may be associated with lower fees, penalties, or transaction costs to convert to cash. Other parties are more likely to trade for the goods, and there is usually strong accounting guidance for items easiest to value and sell.
There is also a psychological advantage to liquid assets. Some individuals or companies take peace of mind knowing they have resources on hand to meet short-term needs. Instead of having to force-sell assets in a short-term timeframe, liquidity is important as it helps foster a strategic, thoughtful proactive environment as opposed to a reactionary environment.
Financial liquidity also plays a vital part in the short-term financial health of a company or individual. Each have bills to pay on a reoccurring basis; without sufficient cash on hand, it doesn't matter how much revenue a company makes or how expensively an individual's house is valued at. Consider a company with $1 billion of fixed assets but only $1 of cash. This company would be unable to pay its $10,000 rent expense without having to part ways with some fixed assets.
Disadvantages of Liquidity
For some investors and for some circ*mstances, illiquid assets actually hold an advantage over liquid assets. Consider certificate of deposits. CD's often have a higher rate of return than a bank account. If a company or individual can sacrifice liquidity, it may generate higher returns from the asset.
As illiquid assets are more difficult to sell, they also have the advantage of potentially being less volatile. Imagine two assets: one is a single share of public stock for Amazon, one is a single acre of farmland in Riverdale, North Dakota. As investors can not panic sell the farmland but can emotionally trade the single share of public stock, illiquidity may protect investors from themselves and force them to hold assets through market turbulence.
Financial Liquidity
Pros
Assets are often associated with lower fees, penalties, or transaction costs.
Assets are often widely accepted by others and can be easily exchanged.
Assets often have public pricing, making these assets easiest to value.
Assets provide greatest peace of mind regarding meeting short-term needs.
Assets create the best short-term financial health prospects.
Cons
Assets often yield lower returns than illiquid asset due to lower incurred risk.
Assets may be less volatile as it is more difficult to sell.
Assets may be more intrinsically special (i.e. 1:1 collectibles holding value beyond financial valuation.
Example of Financial Liquidity
In the fiscal year 2021, Disney reported total revenue of $67.4 billion. The company also emerged from the pandemic and reported a net income of $2.5 billion, turning the company around from a loss in 2020. It could be argued that Disney's financial performance in 2021 was better than in 2020.
However, digging into Disney's financial liquidity might paint a slightly different picture. At the end of fiscal year 2021, Disney reported having less than $16 billion of cash on hand, almost $2 billion less than the year before. In addition, the company's total current assets decreased by roughly $1.5 billion even though the company's total assets increased by over $2 billion.
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Looking at Disney's liabilities, the company ended fiscal year 2021 with just over $31 billion of total current liabilities. This is an increase of over $4 billion from the year prior. Each of the company's accounts payable, current portion of borrowings, and deferred revenue balances increased from the year prior. Analyzing Disney's current ratio shows the company's liquidity worsened:
Current Ratio (2021): ($33.657 / $31.077) = 1.08
Current Ratio (2020): ($35.251 / $26.628) = 1.33
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Therefore, although Disney outperformed the year prior and generated more sales in 2021 than 2020, the company's liquidity worsened. At the end of 2021, the company had less short-term resources to meet short-term obligations.
What Does Liquidity Mean?
For a company, liquidity is a measurement of how quickly its assets can be converted to cash in the short-term to meet short-term debt obligations. Companies want to have liquid assets if they value short-term flexibility.
For financial markets, liquidity represents how easily an asset can be traded. Brokers often aim to have high liquidity as this allows their clients to buy or sell underlying securities without having to worry about whether that security is available for sale.
What Are Some Examples of Liquidity?
Imagine a company has $1,000 on hand and has $500 worth of inventory it expects to sell in the short-term. In addition, the company has $2,000 of short-term accounts payable obligations coming due. In this example, the company's net working capital (current assets - current liabilities) is negative. This means the company has poor liquidity as its current assets do not have enough value to cover its short-term debt.
A non-financial example is the release of popular products that sell-out immediately.
Why Is Liquidity Important in Financial Markets?
Liquidity is important in financial markets as it ensures trades and orders can be executed appropriately. Within financial markets, buyers and sellers are often paired based on market orders and pending book orders. If a specific security has no liquidity, markets cannot execute trades, security holders can not sell their assets, and parties interested in investing in the security can not buy the asset.
How Can a Company Measure Liquidity?
There are several financial ratios used to calculate a company's liquidity. Liquidity ratios typically compare a company's current assets to its current liabilities to measure what short-term assets it has available to pay for its short-term debt. Specific liquidity ratios or metrics include the current ratio, the quick ratio, and net working capital.
The Bottom Line
Liquidity is important among markets, in companies, and for individuals. A company or individual could run into liquidity issues if the assets cannot be readily converted to cash. For companies that have loans to banks and creditors, a lack of liquidity can force the company to sell assets they don't want to liquidatein order to meet short-term obligations.
Market liquidityis criticalif investors want to be able to get in and out of investments easily and smoothly with no delays. As a result, you have to be sure to monitor the liquidity of astock, mutual fund, securityorfinancial marketbefore entering a position.
