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What is liquidity and why is it important for equities and financial assets?

What is liquidity and why is it important for equities and financial assets?

Liquidity is a term you hear regularly in all financial markets, regardless of the class of assets you follow. The term has to do with your ability

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Liquidity is a term you hear regularly 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 is also a measure of a company’s financial stability.

But what exactly is liquidity, how do you measure it, and why are investors in love with it? Read on to find out!

What is liquidity?

Liquidity is a measure of how easy it is to convert an asset into cash without changes in the market price.

Gold, for example, is a highly liquid asset because it can be quickly converted into cash at a fair market price. On the other hand, a piece of real estate is much less liquid. Although a piece of real estate is a solid investment, it can take weeks, months or even years to find the right buyer who is willing to give you the fair market value when you decide to sell.


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There is also another way to look at liquidity in the stock market.

Investors and analysts use liquidity ratios to determine a company’s ability to cover its short-term liabilities by using liquid assets on its balance sheet. In this context, high liquidity means that the company is more than able to pay its debts, while less liquid companies may fail if things do not go as planned.


Types of liquidity

There are three types of liquidity. Each provides unique insights that you can use to improve your outcomes when working in financial markets. The three types of liquidity are:

Asset Liquidity

An asset’s liquidity is a measure of how easy it is to sell an asset quickly at a fair market value. It is measured on an asset-by-asset basis, and it is largely based on the trading volume of the asset.

Apple (AAPL), for example, 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 shares trade 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 much more liquid than OMNIQ’s. This means that if you own a significant position of Apple shares, you will be able to download your shares quickly without affecting market value. On the other hand, if you have a significant position in OMNIQ stocks, it will probably take several trading sessions to download your stocks without making a significant impact on the stock’s price.

Market liquidity

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 arts market. Some stocks are more liquid than others, and some are completely illiquid, but chances are good that you will have an easier time selling stocks at a fair price than selling a work of art.

Accounting Liquidity

Accounting liquidity refers to a company’s ability to pay off its short-term debt using its current assets, or assets that can easily be converted into cash over the course of the next year.

Say, for example, companies ABC and XYZ both have $ 50 million worth of short-term liabilities. However, Company ABC has $ 75 million in current assets, while Company XYZ has $ 25 million in current assets. In this case, ABC has many assets at hand to cover its debt, which means that its liquidity is in good condition.

On the other hand, company XYZ will have to raise money or restructure its debt if things go wrong because it does not have enough assets to cover its liabilities. 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 differently. Here’s how to measure liquidity in finance:

How to measure asset liquidity

An asset’s liquidity is measured by the number of times an asset trades in the course of a predetermined period of time.

For example, a stock’s liquidity is measured by its average trading volume. Shares that trade more hands in the average trading session are more liquid than those that trade fewer hands.

You can trade volume data at Yahoo! Finances or similar sources of stock quotations. Just type the company name in the search bar and search for “Average Volume” in the data next to the inventory chart.

How to measure market liquidity

Market liquidity is usually measured by comparing the prices that sellers ask (ask) with the prices that buyers are willing to pay (bid) in what is known as a bid-ask spread. In a high-liquidity market, the bid-ask spread is minimal, which means that 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 larger, which means buyers are generally unwilling to pay the prices that sellers ask. Consequently, sellers in low-liquidity markets must either sell their assets at a discount to make a sale move fast or wait weeks, months or even years for a buyer 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 off 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. Generally, a value of 1 or higher is considered positive. These include:

Current relationship

The current ratio is the easiest way to measure a company’s accounting liquidity. It compares the company’s current assets with its current liabilities using the equation below:

Current ratio = Current assets ÷ Current liabilities

Using the examples of company ABC and XYZ above, the equations look like this:

ABC’s current ratio = $ 75 million ÷ $ 50 million = 1.5

and

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 will want to stay away from XYZ.

Fast ratio (also known as acid test ratio)

The fast ratio follows the same lines as the current ratio, but does not include all current assets. This ratio is only responsible for assets that are easily converted into cash within 90 days at a fair market price. Those assets include cash and cash equivalents, receivables and short-term investments. The formula for the ratio is as follows:

Quick ratio = (Cash & Cash equivalents + Debtors + 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 debtors. The rest of its current assets will take more than 90 days to reasonably convert into cash. The company has $ 50 million in short-term liabilities; in this case the formula will look like this:

ABC fast ratio = ($ 20 million + $ 20 million + $ 5 million) ÷ $ 50 million = 0.9

In general, investors are looking for a quick ratio above 1. In this example, ABC’s ratio is a cautionary flag.

Cash ratio

A company’s cash ratio is the most telling because it compares a company’s cash and cash equivalents to its debt. 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 relationship that shows whether a company would have the cash flow to stay out of default if an expensive, unforeseen event were to occur.

As in the examples above, company ABC says it has $ 20 million in cash and cash equivalents and $ 50 million in short-term liabilities. 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 higher. So, in this example, the cash ratio of 0.4 indicates that ABC may face some financial hurdles going forward.


Why liquidity is important

Liquidity is important for several reasons:

  • Your ability to go out. Both market liquidity and asset liquidity indicate your ability to exit an investment when you decide it’s time to sell. This is an important consideration when choosing an investment. If you are investing money that you have not needed for years, it is good to consider illiquid options. However, if you need the money in the short term, you should only invest in the most liquid assets found in the most liquid markets.
  • A Company ability to pay debts. You do not want to invest in a company that is likely to go bankrupt. That’s how losses happen! You can avoid these landmines in the market by determining a company’s financial health by using liquidity ratios before making an investment.

Liquidity Frequently Asked Questions (Frequently Asked Questions)

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. In addition to cash, other highly liquid assets include marketable securities – equities and securities traded on public exchanges – money market account balances, savings account balances and gold and other precious metals.

What are the best measures of liquidity in equities?

Stock liquidity is best measured by looking at two measures: the bid-ask spread and the trading volume. Stocks with a 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 a wide bid-ask spread do not have liquidity.

What happens if the liquidity is low?

When liquidity is low, investors who want to sell should either wait for the right buyer to buy their assets or sell their assets at a discount.

If liquidity remains too low for too long, current investors often become frustrated and the stock struggles to attract new investors, leading to declines.


Final Word

Liquidity is one of the most important financial terms for investors because it shows how long it will take you to get a fair price when you leave investments and gives you clues about the financial stability of the companies in which you are interested in investing.

High and low liquidity are not good or bad things. They are both suitable for different investors, and you may be suitable for investing in a mix of both. The key is how long you plan to keep the investment.

If you are planning to invest for the long term and do not expect to need the money you are investing for the coming years, some low-liquidity options such as wine and fine arts offer exciting potential returns. However, if you may need your investment dollars back soon, it is best to invest in high-liquidity assets such as stocks, gold and money market accounts.

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