Liquidity explained

Liquidity is an economic notion that refers to the ability to convert assets and obligations. It may consist of the following:

• The ease with which an asset can be sold on the market is known as market liquidity.
• Accounting liquidity refers to a company’s capacity to satisfy its cash obligations on time.
• The quantity of money held by a company is known as liquid capital.
• Liquidity risk refers to the possibility that an asset’s market liquidity will be harmed.

Liquidity process

To put it another way, liquidity refers to the ease with which an item can be bought or sold in the market at a price that reflects its true value. Cash is usually regarded as the most liquid asset since it can be transformed into other assets quickly and easily. Real estate, fine art, and collectibles, for example, are all relatively illiquid assets. Other financial assets, such as equity and partnership units, fall into other liquidity categories.

Importance of liquidity

It becomes difficult to sell or convert assets or securities into cash if markets are not liquid. For example, you might hold a $150,000 family heirloom that is extremely rare and precious. However, if your object has no market (i.e. no buyers), it is meaningless because no one will pay anywhere near its rated value—it is extremely illiquid. It may even be necessary to hire an auction house to act as a broker and locate potential buyers, which may take time and money.

Measuring Liquidity

Financial analysts examine a company’s ability to cover short-term obligations using liquid assets. When employing these calculations, a ratio greater than one is generally preferred.

Current Ratio

The current ratio is the most straightforward and least stringent. It compares current assets (those that can be converted into cash in less than a year) to current liabilities (those that can be converted into cash in less than a year). Its formula would is as follows:

Current Ratio = Current Assets / Current Liabilities

 

Quick Ratio 

The fast ratio, often known as the acid-test ratio, is a little more stringent. Inventory and other current assets are not included since they are not as liquid as cash and cash equivalents, accounts receivable, and short-term investments. The formula is as follows:

Quick Ratio = (Cash and Cash Equivalents + Short-Term Investments + Accounts Receivable) / Current Liabilities

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