Liquidity
Liquidity is the ease with which an asset can be converted into cash without materially affecting its market price. Highly liquid assets convert quickly and with little cost; illiquid assets take longer and often require discounts or transaction costs.
Types of liquidity
- Market liquidity: How easily assets can be bought or sold in a given market at stable, transparent prices. High market liquidity features narrow bid-ask spreads, deep order books, and active trading volume. Real estate and many collectibles typically have low market liquidity; major exchange-traded stocks and government bonds generally have high market liquidity.
- Accounting liquidity: A measure of an individual’s or company’s ability to meet short-term obligations using available liquid assets. This reflects whether assets on the balance sheet can be converted to cash quickly enough to cover liabilities due within a year.
How liquidity is measured
Common accounting liquidity ratios compare liquid assets to current liabilities:
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Current ratio = Current assets ÷ Current liabilities
(Broad measure; includes inventories and other current assets.) -
Quick ratio (acid-test) = (Cash and cash equivalents + Short-term investments + Accounts receivable) ÷ Current liabilities
(Excludes inventory and prepaid items; stricter than current ratio.) -
Cash ratio = Cash and cash equivalents ÷ Current liabilities
(Strictest measure; assesses ability to meet short-term obligations in an emergency.)
For market liquidity, useful indicators include:
– Trading volume (higher volume usually means easier execution)
– Bid-ask spread (narrower spread indicates higher liquidity)
– Market depth and the order book (ability to absorb large orders without large price moves)
– Presence of market makers and active participants
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Examples
- A rare-book collection appraised at $1,000 is illiquid if finding a buyer at that price would take months; in a hurry, the seller may accept a discount.
- Equities as a class are liquid, but liquidity varies by stock. Large-cap, widely followed stocks often trade millions of shares daily and are easier to buy or sell without moving the price. Small-cap or thinly traded stocks have wider spreads and lower depth.
Most and least liquid assets
- Most liquid: Cash and cash equivalents (money market accounts, short-term Treasury bills), major exchange-traded stocks and bonds, and highly traded marketable securities.
- Least liquid: Unique collectibles, fine art, private business interests, certain OTC derivatives, and real estate (sales can take weeks to months and involve significant fees).
Why liquidity matters
- For individuals: Liquid assets enable timely purchases and coverage of unexpected expenses without forced selling at a loss.
- For companies: Sufficient accounting liquidity prevents cash-flow crises (missed payroll, unpaid bills) that can lead to insolvency or bankruptcy.
- For markets: Liquidity supports efficient price discovery and lowers transaction costs; illiquid markets amplify price volatility and raise selling costs.
Assessing stock liquidity
Look beyond raw volume:
– Compare average daily volume, bid-ask spread, and market depth.
– Check order-book data and the number of active market participants or market makers.
– Higher trading volume plus tight spreads and deep order books signals a more liquid stock.
Key takeaways
- Liquidity is about converting assets to cash quickly and at little cost.
- Market liquidity (tradeability) and accounting liquidity (ability to meet obligations) are distinct but related concepts.
- Use current, quick, and cash ratios to evaluate accounting liquidity; use volume, spreads, and market depth for market liquidity.
- Maintaining adequate liquidity helps individuals and firms manage short-term needs and avoid costly distress.