- Liquidity refers to how much cash is readily available, or how quickly something can be converted to cash.
- Market liquidity applies to how easy it is to sell an investment — how big and constant a market there is for it.
- Accounting liquidity refers to the amount of ready money a company has on hand; investors use it to gauge a firm's financial health.
In finance, the current market value of an asset isn't the only factor that matters, because an asset that you can't trade or convert to cash doesn't hold much practical value. For example, if you own a rare coin with an assessed value of $10,000, but you can't find a buyer, then it doesn't really matter whether the coin is supposed to be worth $10,000 or $1,000.
On the other hand, if you own $9,000 worth of stocks that can be easily sold for cash within a few days if you need the money, then that might be more valuable to you than the coin with a supposed market value of $10,000.
In this example, the difference between these assets — the stocks and the coin — is liquidity.
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. Liquidity can also refer to the financial health of a market as a whole, such as whether there are enough buyers and sellers to allow for efficient trading.
Similarly, liquidity can apply to personal or corporate finance, in the sense of liquidity referring to the ability to meet short-term debt obligations or generally being able to convert assets to cash.
In general, high liquidity is positive. Having liquid assets (e.g., cash savings and assets like frequently traded ETFs in your investment portfolio) can mean that you're well-positioned to face unexpected costs and can maneuver through various financial situations more easily.
That said, some illiquid assets have their place. For instance, owning a home might mean a lot of your money is tied up in one asset that you can't easily convert to cash, but it could be worth it if your home appreciates in value and you save money over the long run vs. renting. 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.
Here, we'll take a closer look at what liquidity means in different situations, how to measure it, and more.
What is liquidity?
To understand liquidity, helps to think of the word literally. 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.
That said, liquidity can mean slightly different things in different contexts.
Simple definition
The simple definition of liquidity for financial assets is that it refers to how easily an asset can be converted to cash, without that conversion negatively affecting the price. 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.
Financial contexts
To better understand liquidity, it helps to look at this concept in specific financial contexts.
For assets, liquidity refers to how efficiently these can be sold. If a stock you own is quoted at $50.10, and you can sell it within seconds after listing it for sale for $50.09 (there's typically a gap between the stock quote and the actual bids buyers put in), then it's highly liquid, because you can quickly convert that asset into cash without taking a significant hit on the price.
But suppose there were few buyers for that stock. Maybe you have to drop the price down to $49.90 to find a buyer willing to complete the trade within seconds. There's still some liquidity there based on the speed, but the liquidity isn't quite as high as the stock that essentially trades at its quoted value right away.
For markets as a whole, liquidity refers to the flow of activity. 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.
For companies and individuals, liquidity still refers to the ease of financial flows, but more so in the context of meeting short-term financial obligations. For example, a company that has strong liquidity might have twice as much cash on hand as current liabilities, e.g., debt payments and payroll expenses. That liquidity is important, because if something unexpected happens, like if the company doesn't get paid by a major customer, it will still have enough cash to cover liabilities for the time being.
The liquidity spectrum
Liquidity isn't a black-or-white issue. Assets tend to fall on a liquidity spectrum, ranging from:
- Most liquid: Cash is generally the most liquid asset, but some cash-like instruments such as money market fund shares or Treasuries are also considered to be at the top end of the liquidity spectrum, as it's very easy to convert these to cash or trade for similar assets, usually without significantly affecting the price.
- Highly liquid: Assets like most stocks, highly rated corporate and municipal bonds, and ETFs are considered highly liquid. These can almost be converted into cash as efficiently as cash-like instruments, but there might be slightly more delay in terms of finding a trading partner without significantly affecting the price. That said, there's variation within these groups. Penny stocks, for example, are often less liquid than S&P 500 stocks, because there are typically fewer buyers and sellers, so it can be harder to reach a fair price.
- Less liquid: Some assets like real estate or collectibles can take a while to find a buyer, unless you're willing to sell them at a steep discount, which means they're less liquid than some of the aforementioned assets.
- Illiquid: Some investments are for all intents and purposes illiquid, such as some private equity and hedge fund investments that have a lock-up period where investors can not exit their positions. In private equity, for example, an investor might not be able to get their initial investment back for 10-12 years until the fund closes and disperses capital and sometimes most of the returns back to investors. The tradeoff is that illiquid investments often come with benefits like higher return potential.
Types of liquidity
Liquidity comes in two basic forms: market liquidity, which applies to investments and assets, and accounting liquidity, which applies to corporate or personal finances.
Market liquidity
Market liquidity is the liquidity of an asset and how quickly it can be turned into cash — in effect, how marketable it is, at prices that are stable and transparent. It can also apply to a market as a whole.
High market liquidity means that there is a high supply and a high demand for an asset and that there will essentially always be sellers and buyers for that asset, or the overall group of assets that trade within that market. If someone wants to sell an asset yet there is no one to buy it, then it cannot be liquid.
Liquidity is not the same thing as profitability or market returns. Shares of a publicly traded company, for example, are typically liquid, meaning they can be sold quickly on a stock exchange, but that might occur after the stock dropped in value. However, the drop is caused by the market participants agreeing on the lower valuation, rather than a lack of liquidity affecting the price.
Accounting liquidity
Accounting liquidity is a company's or a person's ability to meet their financial obligations — the money they owe, either as upcoming expenses or debt payments. Usually this applies to short-term obligations, i.e., those occurring within a year.
With individuals, figuring liquidity is generally a matter of comparing their short-term debts and expenses to the amount of cash they have in the bank or the marketable securities in their investment accounts.
With companies, the calculations can get a tad more complex, but still generally refer to how their short-term assets match up against short-term liabilities.
Why liquidity matters
Liquidity can significantly affect the financial health of markets, companies, and individuals. However, high liquidity isn't always better than illiquidity, as some investors view investments in illiquid private equity funds as worthwhile. Still, it's important to consider liquidity to ensure that you won't have to go into debt if you face unexpected expenses.
Here are some of the more specific reasons why liquidity matters to different stakeholders:
Investors
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. So, it might not be worth it to you to hold some illiquid investments, even if the potential returns are high, if you don't want to face the risk of not being able to exit your position quickly or having to sell at a steep discount to do so.
And it's not always about needing cash in an emergency. Sometimes investors want liquidity to try to take advantage of opportunities. 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 an asset like an NFT, maybe you wouldn't be able to find a buyer in time to close the real estate deal.
Companies
For companies, strong liquidity generally signals financial health and makes it easier to both meet current obligations while being in position to take advantage of new opportunities.
For example, say a company had a monthly loan payment of $5,000. Its sales are doing well and the company is realizing profits. It has no issues in meeting its $5,000 monthly obligation, while also having the liquidity from its profits to invest in a new facility or staff.
Now say the economy suffered a sudden economic downturn. Demand for the business's products has vanished so, therefore, it is not bringing in revenue and making profits; however, it still has to meet its $5,000 monthly loan bill.
In this scenario, the company only has $3,000 of cash on hand and no liquid assets to quickly sell for cash. It will default on its loan within one month, because it has low overall liquidity. Now if the company had a buffer of $10,000 in cash and other liquid assets like bonds worth $15,000 that it could sell in a few days for cash, it would be able to meet its debt obligations for many months to come, hopefully until the economy rebounds.
Financial markets
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. It's not as if a buyer can convince a seller to make the trade at a low price, because there are plenty of other buyers willing to make the trade at a fair price.
High liquidity gives investors confidence, thereby helping to encourage investment and ensuring that money can flow as needed among buyers and sellers.
Conversely, a financial market with low liquidity can cause problems. If the lending market has low liquidity, for example, because banks are nervous about the economy, it can be hard for companies and individuals to obtain loans for things like expanding businesses and buying real estate or vehicles. In turn, that can cause a downward economic spiral, where the economy contracts, thereby drying up liquidity even further.
How liquidity is measured
Measuring liquidity depends on the context. A few ways to do so include the following:
Market liquidity
When looking at market liquidity, either for individual assets or markets as a whole, some common metrics include:
- Bid-ask spread: The bid-ask spread is the gap between what buyers are willing to pay for an asset (the bid) and what sellers are willing to accept for an asset (the ask). When there's a wide bid-ask spread, that signals low liquidity, because investors are unlikely to quickly find a trading partner at an agreeable price — either the buyer has to pay more than what they think is fair or the seller has to accept less, and it can take a while to reach an agreement.
Bid-ask spreads vary by asset. It might be a one-cent gap for commonly traded stocks, meaning they're highly liquid, or it might be several dollars for some options where there's not enough buyers and sellers to form a tight consensus.
- Trading volume: Trading volume also generally coincides with liquidity. Typically, high trading volume leads to tighter bid-ask spreads, but even if those are wide, having high trading volume at least enables some liquidity in the sense it's an active market. If investors need to sell their assets for cash, they have a better chance of finding a buyer at an agreeable price when there's high trading volume.
Accounting liquidity
Three liquidity ratios are primarily used to measure a company's accounting liquidity:
- Current ratio
- Quick ratio
- Cash ratio
How current ratio is calculated
The current ratio is calculated as current ratio = current assets/current liabilities. Current assets generally refers to assets that can be expected to be converted to cash or used within a year, while current liabilities usually means debts or expenses due within a year.
The current ratio is also known as the working capital ratio and seeks to determine a company's ability to meet its short-term obligations that are due within a year. The higher the ratio, the better a company's financial health is and the stronger its ability to meet its financial obligations.
For example, if a company has current assets of $3 million and current liabilities of $2 million, it will have a current ratio of 3/2 = 1.5. If it has current assets of $8 million and current liabilities remain at $2 million, it will have a current ratio of 8/2 = 4.
How quick ratio is calculated
There are two formulas that can be used for the quick ratio: quick ratio = (cash + marketable securities + accounts receivable)/current liabilities, or quick ratio = (current assets - inventory - prepaid expenses)/current liabilities. The quick ratio, aka the acid test ratio, measures a variation of current assets against current liabilities by accounting more so for assets that can be quickly converted to cash.
In its calculation, it only uses the most liquid assets: cash, marketable securities, and accounts receivable. It does not include inventory, which the current ratio does, as inventory cannot be sold as quickly as the other assets.
Here too, the higher the ratio, the better a company is situated to meet its financial obligations.
How cash ratio is calculated
The cash ratio is calculated as cash ratio = cash/current liabilities. The cash ratio is an even more stringent ratio than the quick ratio. It compares only cash to current liabilities.
If a company can meet its financial obligations through just cash without the need to sell any other assets, it is in an extremely strong financial position.
While the meanings can differ a bit based on what ratio you're using, generally, the results indicate the following:
- A value of 1 indicates that a company's liquid assets are equal to its current liabilities
- A value above 1 indicates that a company has more liquid assets than current liabilities.
- A value below 1 indicates that a company has more current liabilities than liquid assets and is not in a position to meet its financial obligations.
When comparing liquidity ratios, it is important to only compare companies within the same industry. This is because every type of industry is going to have different asset and debt standards.
For example, a technology company does not operate the same as an airline company. The tech firm might need to buy computers and office space, while an airline needs to buy higher-cost assets like planes. So it's natural for an airline company to carry higher levels of debt.
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.
Factors affecting liquidity
Liquidity is not always constant. There can be many factors that affect different types of liquidity, such as:
Economic conditions
During periods of economic growth, liquidity might be strong, such as if companies have higher profits that outweigh debts. During economic downturns, however, liquidity might dry up. For financial assets, for example, there might be lower trading volume if there are fewer buyers interested in investing during the downturn.
Market sentiment
Even if the economic conditions are strong, market sentiment can still affect liquidity. For example, if investors are fearful of a possible recession, that alone could cause a liquidity crisis. Investors might favor assets that are already very liquid, like Treasuries, while other assets like some stocks that are normally quite liquid become less liquid, due to lower buying demand.
Regulatory changes
Regulation can also affect liquidity in many ways, ranging from inspiring investor confidence which could increase liquidity, to requiring financial institutions to hold more liquid assets, which could decrease liquidity in other parts of the financial system, like lending.
FAQs about liquidity
What are the most liquid assets?
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. Publicly traded stocks, particularly of large companies, and highly rated corporate and municipal bonds are also considered highly liquid, though not quite as liquid as cash and cash-like instruments.
How does liquidity risk impact investors?
Illiquidity increases the risk that investors will not be able to sell their assets when needed, which could cause them to incur borrowing costs. Or, they might have to sell assets at less than what's considered a fair price to get out quickly. Liquidity risk management could involve holding assets of varying liquidity levels to be able to meet short- and long-term goals.
How can companies improve their liquidity?
Companies can improve liquidity by maintaining a cash or cash-like buffer, improving their cash flow such as by cutting expenses, and potentially gaining proactive access to credit to draw from as needed, which wouldn't necessarily improve liquidity ratios but could increase liquidity from the perspective of practically meeting short-term obligations.
