When investing in the financial markets, liquidity is an important factor to take into account. Simply put, liquidity is how easily an asset can be converted into cash without having a negative impact on its price. However, there are different aspects to liquidity, all of which should be considered when making an investment. This article discusses those aspects, ways to measure liquidity and liquidity risk.
As mentioned, liquidity refers to the degree to which an asset can be bought or sold without impacting its price. In an investing context, assets, markets and companies themselves can be more liquid than others.
Liquidity of assets— Different financial products and assets can be more liquid than others. An asset with high liquidity can be more quickly bought and sold than an illiquid asset and it is also easier to sell it for the market price. Cash is the most liquid asset, whereas real estate or a rare painting, for example, can be less liquid because you may not be able to sell it immediately.
Stocks and bonds are generally considered liquid products; however, some may be more liquid than others. For example, large-cap companies that trade on major exchanges tend to be more liquid compared to small-cap stocks that are listed on smaller exchanges.
Market liquidity— Aside from assets, markets, such as stock markets or real estate markets, fall somewhere on the liquidity spectrum. Market liquidity is how easily assets can be bought or sold for fair prices. For example, the market for rare paintings can be less liquid than stock markets as there may be fewer buyers and sellers in that niche market.
In an illiquid market, there are not a lot of buyers and sellers. This can make it difficult for you to buy or sell at the time and price you want. Therefore, illiquid markets can be riskier than liquid markets. With stock markets, you can get an idea of the liquidity based on the bid-ask spread whereby a larger spread can indicate less liquidity.
Accounting liquidity— Accounting liquidity is a company’s ability to pay off current liabilities that are due within one year with its current assets on hand. It is one of many factors to consider when determining a company’s financial health.
Examples of a company’s current assets are cash, marketable securities, inventory and accounts receivable. These are reported on a company’s balance sheet and are generally listed from most liquid to least. Examples of current liabilities are accounts payable, short term debt, dividends payable, interest and taxes.
Below are liquidity ratios commonly used to measure a company’s liquidity. If a company has poor liquidity levels, it can indicate that the company will have trouble growing due to lack of short-term funds and that it may not generate enough profits to its current obligations. On the other hand, if a company has very high liquidity levels, it can indicate that the company is not properly investing funds. Generally, a ratio greater than one is desirable for all of the below.
Current ratio— This measures current assets against current liabilities, indicating a company’s ability to pay off short term debts with short term assets on hand. The formula is:
Current ratio = Current assets / Current liabilities
Quick ratio— Also known as the acid-test ratio, this is similar to the current ratio but it does not include assets that are less liquid such as inventory. The formula is:
Quick ratio = (Cash + Cash equivalents + Account receivables) / Current liabilities
Cash ratio— This measures a company’s ability to pay off short term liabilities with only cash and cash equivalents. The formula is:
Cash ratio = (Cash + Cash equivalents) / Current liabilities
Similar to liquidity, there are several ways to look at liquidity risk. Regarding assets, some can be riskier than others. Going off of the earlier example, stocks can be more liquid than a rare painting. Generally speaking, assets that are more liquid tend to be less risky. Therefore, in terms of liquidity, purchasing a stock may be less risky than a rare painting.
Regarding accounting liquidity, liquidity risk in this case is the risk that a company cannot meet its short-term financial demands. Of course, when a company is suffering financially, this can then reflect negatively on share prices, and thus your investment if you are a shareholder.
No matter the liquidity, however, investing always involves a risk of loss. You can lose (a part of) your deposit. We advise you to only invest in financial products that match your knowledge and experience.
The information in this article is not written for advisory purposes, nor does it intend to recommend any investments. Investing involves risks. You can lose (a part of) your deposit. We advise you to only invest in financial products that match your knowledge and experience.