Understanding Liquidity

Last Updated July 26th 2021
7 Min Read

Having assets is a good indicator of the healthy state of any organisation. Every balance sheet needs them and it is when these are more than its liabilities that a business is generally considered to be in good shape. 

But just as having a steady asset base is a desirable situation, it is equally important to have a portion of it readily usable when an emergency arises. This quality of an asset to be easily and efficiently converted into hard cash is what liquidity is all about. 

What is Liquidity?

Even at an individual level, we all have our assets that include the money in our bank accounts, investments like mutual funds, real estate and so on. Here too, it is fairly easy to distinguish the ones that are liquid and those that are illiquid. Nothing can be as liquid as the cash in your wallet and, at the other end of the spectrum, your home or real estate can take some time and effort to liquidate into cash. 

When an asset is likely to be sold off easier than others, their value in terms of the cash they generate becoming handy to meet expenses becomes higher. A business organisation faces this situation day in, day out when its operating expenses are dependent on its having ready access to liquid funds. Usually, this is managed with the cash flow. 

It is during a scenario that warrants raising funds at short notice that liquidity of assets becomes a priority. The challenge here is to ensure that an asset here gets sold off at a price closest to its market value. In certain situations, it may be incumbent on the business to prioritise a quick sale at the best possible price over a slower sale at a more profitable one. 

This is where the requirement to have an adequate portion of the assets being of an easily saleable nature at all times becomes essential. To this end, businesses have to make sure that an appropriate part of the overall assets can be easily converted into cash when required. Examples of such assets include stocks, money market funds, mutual funds, bonds, time deposits, and of course, cash itself. It must be added here that some investments like stocks and mutual funds may get liquidated in a short period but may not fetch the expected price. 

Examples of illiquid assets for individuals include their home, car, any timeshare or any item as part of heirloom like antiques and so on. These may all be worth a lot but getting their sale done to raise cash can be time-consuming and may not fetch their due price too. For businesses too, there are illiquid assets held and these may again include real estate, company vehicles, collectables and holdings in other companies, to name a few common ones.  

Examples of Liquid Assets

  • Cash and currency: Cash is the most liquid type of asset. 
  • Bank accounts: Funds that you can withdraw from your bank accounts.
  • Accounts receivables: The balance of money owed to your business not yet paid for by customers.
  • Mutual funds: An investment scheme where funds are pooled and invested in different securities
  • Money market funds: A low-risk, high-yield savings account.
  • Stocks: The shares you own.
  • Bonds, treasury bills and notes: Long-term investment options that have a variety maturity dates when you will receive your principal back.
  • Certificates of deposits: An account with a specific withdrawal date for a fixed amount of money with a fixed rate of interest.
  • Prepaid expenses: Future expenses like rent and insurance that are paid ahead of schedule. 
  • Retirement investment accounts: Accounts like IRA and 401(k)s that allow individuals to save for retirement with tax-free growth or on a tax-deferred basis.

Examples of Non-liquid Assets

  • Real estate investments: This includes commercial and residential properties or land. It can take months or years to receive cash from the sale.
  • Equipment and machinery: Equipment or machinery that are required for a business to operate, with no expectation that they will be sold or converted to cash.
  • Vehicles: Recreational vehicles have strong monetary value, but take time and resources to sell.
  • Jewellery: Can fetch large sums, but is difficult to find a buyer or broker.
  • Art, artefacts, antiques and collectables: Can appreciate strongly but will be hard to find a buyer or broker. 

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Types of Liquidity

While liquidity, in itself, is about the availability of assets that is cash or can take a cash form easily, there are two types of liquidity that apply in the business context. 

Market liquidity

When a market does not have the capability to allow for transactions to happen easily and frequently, this denotes a lack of liquidity. The real estate market is a classic example of this where the chances of a home or any property, for that matter, getting sold is dim. There are phases in the property market from time to time when there just are not many buyers and the unsold inventory of new units or that of resale get caught in limbo. This can be true of other domains too, like the used car market. 

The stock market is relatively liquid and most stocks do get sold even when there is no bull run. But the liquidity apart, you may not be able to sell it at the expected price. It is when the difference between the bid and ask price becomes wider, liquidity could be hit here too. 

Typically, for financial products like currencies, commodities, derivatives and the like, liquidity is usually a function of the number of exchanges they trade on and the quantity that is up for sale. There is, of course, the market conditions and sentiments that are factors too. 

Accounting liquidity

Accounting liquidity, however, is more a measure of the ease with which business obligations can be managed with the available assets in liquid form. This is, in other words, the relationship between liquid assets to the debts and liabilities outstanding. This is, in accounting terms, calculated for a period of one year. 

The state of accounting liquidity is an important metric for market and industry analysts who track companies that have a healthy liquidity ratio and record. The better the ability of a business to have access to cash or liquidate their assets quickly and easily to raise cash, the better it performs in this analysis.

The Importance of Liquidity

Even at an individual level, having a wide asset base is of little use if there is no liquidity during an emergency that requires access to cash. So, obviously, in a business scenario, liquidity is crucial to run a company that is both profitable and has quick and easy access to liquid funds from its many assets. 

Whether it is a business expansion or upgrading its technology or having to spend for vital equipment or any other pressing need at all, it is critical that an organisation does not have to delay or slow down actions for want of funds. 

Even if it is not about liquidating one of its assets, having ample liquidity is an important consideration to raise loans too. Lenders will need to be assured that businesses always have the ability to repay debt and adequate liquid assets can be a safety net here. The assets to liabilities ratio, ideally, should be low and this can only happen when the company balances its liquid and non-liquid asset holding. 

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How to Measure Liquidity

With the focus on a company’s effective use of its liquid assets to manage its short term financial obligations, it becomes important to have a way to measure liquidity. 

Just the balance sheet is a good starting point to check where the financials stand in this regard. This will give a clear picture of both the assets and the liabilities, to begin with. 

Based on these inputs, there are various ratios that can be used to make a clearer and more complete assessment of the liquidity of the company’s assets. These ratios provide a good pointer to not just the company management but also internal and external stakeholders, potential investors and lenders. 

The current ratio

The current ratio is a fairly straightforward approach to measuring liquidity. Basically, it is the result of current assets divided by the current liabilities. Here, the current assets are essentially the ones that the company owns that can be liquidated in a year’s time. 

The quick ratio

With the quick ratio, the current assets and inventories are divided by current liabilities. Here, the more liquid assets like cash, accounts receivables and other investments of a shorter term are not included in the calculation. 

The cash ratio

It is the cash ratio that takes an unyielding approach at assessing the chances of a business surviving an emergency concerning its finances. Without being able to get easy and instant liquidity to face a sudden and unprecedented scenario, even an otherwise established company can stumble. 

Because only cash and investments like short term ones that are easiest to convert to cash are taken in this ratio, this can be quite a demanding one when divided by current liabilities. In short, it is the cash ratio that tests the actual liquidity quotient of an entity. 

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