Understanding Liquidity and How to Measure It
You may, for instance, own a very rare and valuable family heirloom appraised at $150,000. However, if there is not a market (i.e., no buyers) for your object, then it is irrelevant since nobody will pay anywhere close to its appraised value—it is very illiquid. It may even require hiring an auction house to act as a broker and track down potentially interested parties, which will take time and incur costs. Prioritizing the repayment of high-interest debts, such as credit card balances, reduces ongoing financial obligations and frees up more disposable income.
Ranking of Market Liquidity (Example)
For individuals, a common method involves calculating the size of their emergency fund. Financial guidance often suggests having three to six months’ worth of essential living expenses readily available in a savings account or similar liquid vehicle. This provides a clear measure of how long an individual could cover their basic costs without income. For markets as a whole, liquidity refers to the flow of activity.
What are the most liquid assets?
These names tend to be lesser known, have lower trading volume, and often have lower market value and volatility. Thus, the stock for a large multinational bank will tend to be more liquid than that of a small regional bank. That may be fine if the person can wait for months or years to make the purchase, but it could present a problem if the person has only a few days. They may have to sell the books at a discount, instead of waiting for a buyer who is willing to pay the full value.
Financial contexts
Marketable securities, such as stocks and bonds listed on exchanges, are often very liquid and can be sold quickly via a broker. Gold coins and certain collectibles may also be readily sold for cash. Excluding accounts receivable, as well as inventories and other current assets, it defines liquid assets strictly as cash or cash equivalents. There are several ratios that measure accounting liquidity, which differ in how strictly they define liquid assets.
- Suppose you want to try your hand at day trading—scalping a few points of profit within a few minutes or hours.
- For instance, individuals rely on liquid funds to cover routine monthly expenses like rent, utilities, and groceries.
- But assets like real estate, as well as art and jewelry, may be considered highly or even exclusively illiquid.
- Liquidity refers to the ease and speed with which an asset can be converted into cash without significantly losing value.
Maybe you’re holding most of your money in a highly liquid vehicle like a money market fund so that you have cash ready to make a down payment once you find a home you want to buy. Yet if all your cash for the down payment was in liquidity ratio definition and meaning an asset like an NFT, maybe you wouldn’t be able to find a buyer in time to close the real estate deal. Still, you’d likely want some liquid assets, so if you face a situation like needing a home repair, you can sell those rather than having to borrow money. If markets are not liquid, it becomes difficult to sell or convert assets or securities into cash.
The same concept applies to assessing the liquidity of a broader situation, like a company’s balance sheet. If there’s high liquidity, the company’s assets can easily cover their short-term liabilities. If there’s low liquidity, they might need to borrow money to cover expenses or sell assets at a loss.
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- Inventory is excluded because it can sometimes be difficult to convert into cash quickly without a discount.
- For financial assets, liquidity refers to how quickly and easily these can be converted into cash close to their assessed market value, or how efficiently they can be traded for other assets.
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High liquidity gives investors confidence, thereby helping to encourage investment and ensuring that money can flow as needed among buyers and sellers. Liquidity matters to investors because the more liquid an asset is, the easier it is to sell the asset as needed at a fair price. If someone wants to sell an asset yet there is no one to buy it, then it cannot be liquid. In short, liquid assets are those whose potential buyers are numerous, whose demand at a favorable price is relatively high, and whose process of exchange is relatively quick and easy. The harder it is to fulfill these criteria, the more illiquid the asset.
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The liquidity of markets for other assets, such as derivatives, contracts, currencies, or commodities, often depends on their size and how many open exchanges exist for them to be traded on. Another personal liquidity measure involves analyzing cash flow, which is the regular inflow of income compared to recurring outflows of expenses. A positive cash flow indicates that an individual’s income exceeds their spending, allowing for the accumulation of savings and the building of liquid reserves. Conversely, consistently negative cash flow suggests a reliance on debt or drawing down existing assets, which can erode liquidity over time. In accounting and financial analysis, a company’s liquidity is a measure of how easily it can meet its short-term financial obligations. Cash is generally the most liquid asset, while investable assets like money market funds and Treasuries tend to also be very liquid, as there’s generally always demand for these relatively safe assets.
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Accounting liquidity measures the ease with which an individual or company can meet their financial obligations with the liquid assets available to them—the ability to pay off debts as they come due. Investors, then, will not have to give up unrealized gains for a quick sale. When the spread between the bid and ask prices tightens, the market is more liquid; when it grows, the market instead becomes more illiquid. Markets for real estate are usually far less liquid than stock markets.
System-wide liquidity in the financial markets
Finally, slower-to-sell investments such as real estate, art, and private businesses may take much longer to convert to cash (often months or even years). Liquidity within financial markets is also important for the smooth functioning of these markets. For example, liquidity in stock market exchanges like the New York Stock Exchange is typically considered to be high. Stocks that trade on this exchange have plenty of buyers and sellers, to the point where it’s easy to match them up almost instantly at agreeable prices.
Financial analyst reports on companies often include liquidity ratios. Otherwise, an investor might have to calculate it themselves, using the info reported on a company’s financial statements or in its annual report. Something that’s liquid like water flows easily vs. something that’s illiquid like ice. Now apply that concept to finance — high liquidity generally means assets or financial activity flow easily, while illiquidity means they’re relatively stuck. When an asset can be efficiently converted into ready cash without affecting its market value, it is considered a liquid asset. The ability to convert it quickly and efficiently is called liquidity.
If there’s strong liquidity, there are enough buyers and sellers to enable individual assets to have high liquidity. For example, the U.S. stock market is considered liquid, because you can almost always find a buyer for any stock you want to sell almost instantly, without significantly affecting the price. In contrast, the real estate market is relatively illiquid, because it could take months to find a buyer, especially if you want the supposed market price. In the example above, the rare book collector’s assets are relatively illiquid and would probably not be worth their full value of $1,000 in a pinch. In investment terms, assessing accounting liquidity means comparing liquid assets to current liabilities, or financial obligations that come due within one year. Building an emergency fund is an important individual liquidity strategy.