The ability to have purchasing power is considered one of the tenets of financial freedom. When life happens, having assets that are readily available to help buy goods and services is a necessity. But there’s a distinction between paying in cash or credit. Think about buying a car. Everyone knows that the value of a car begins to depreciate the moment you drive it off a lot. To help avoid depreciation, individuals that have the ability will typically pay for a car in cash. When a car is financed, you continue to pay for the car you purchased with interest, even though the car is worth far less.
The roots of the financial crisis were born in an absence of liquidity. Consumers were taking on unsustainable amounts of debt while their salaries, which were being used to finance that debt, were stagnating. Obviously, this was a recipe for disaster, and it was.
For a business, liquidity is equally important. And investors should pay attention to liquidity because it can have an impact on their company’s stock price. This is because analysts use liquidity as one of their fundamental analysis tools to determine the financial health, and growth prospects, of a company.
This article will define liquidity, go over the difference between market liquidity and accounting liquidity and review some of the ways that liquidity is measured.
What is liquidity?
Liquidity is a non-statistical measurement of how easily an asset (cash, securities, collectibles, real estate, etc.) can be bought or sold without affecting the asset’s price. If you can sell an asset quickly and for its full value, that asset is said to have high liquidity (or is “highly liquid”). By contrast, if an asset may have a limited market, may take a long time to sell, and/or may have to be sold at a discount to its real or intrinsic value, it is considered to have low liquidity (or illiquid).
In the scope of liquid assets, cash is considered to be the most liquid of all assets. If your refrigerator breaks down right before a busy holiday weekend, having the available cash to walk into a store and pay cash for a refrigerator. You can have it delivered and the money you paid for it hasn’t lost any of its value. When you finance an item whether it is a refrigerator or a Range Rover, the money you pay is losing its value over time.
On the other end of the spectrum, items such as collectibles would be considered the least liquid when it comes to immediate purchases. This is because although you may have the asset to sell, you would have to find a buyer and depending on the market for that item, that is a process that could take weeks or months. Or, in the worst case scenario, you would have to sell the item for far less than its real or intrinsic value in order for you to sell it quickly.
In the world of investing, investors need to be familiar with both market liquidity and accounting liquidity. Both can help you understand a company’s balance sheet and free cash flow.
Understanding market liquidity
Asset classes have varying degrees of liquidity. Market liquidity helps define how easily an asset can be acquired in the market without undergoing a significant price change. Cash, in the form of money market funds, offer the most liquidity. In most cases, you can write checks against a money market fund just as you would cash. And the cash you get retains its value. Securities trading on the stock market is also considered to be highly liquid because they typically have a substantial trading volume. This means on any given day, investors who are looking to buy or sell securities, should be able to find a buyer or seller and make a trade at their desired price, or at a price that's fairly close to the price they're requesting.
Liquidity in the form of trading volume is something that institutional investors watch closely. When a stock has low trading volume in comparison to other stocks in its sector or with a similar market cap, it can be a signal to investors that there is no significant demand for that security. On the other hand, if a security is experiencing a high trading volume, it is usually a signal that there is a high demand that makes it easier to buy and sell. At different times, an asset class may go through periods where they exhibit more or less liquidity. For example, if a trader is attempting to trade currencies at a time when those markets are not open, they may find a lack of buyers. And most traders know that volume tends to peak at the beginning and the end of a trading day.
In contrast, the real estate market is generally considered less liquid because, as a whole, there is a greater gap between asking prices and selling prices. We all know that when a home has been on the market for some time, a seller will reduce their asking price in an effort to entice buyers. Alternately, in a hot real estate market, a seller may receive offers well above their asking price because of high demand.
This is a good time to bring up an important point about liquidity. Liquidity is frequently thought about in terms of time frame (i.e. how fast can you come up with the money for a purchase). Time certainly plays a factor, but an equally important concept for investors is the ability of an asset to be bought or sold without losing its value.
Understanding accounting liquidity
Accounting liquidity for a company is the same for a company as it for an individual. How easily can a company pay its debts as they come due? One of the easiest ways to evaluate this is to look at a company’s balance sheet. The balance sheet is a snapshot of a company’s financial health at a given moment in time.
At the top of every balance sheet is a list of a company’s assets. They are listed in order from most liquid to least liquid and divided into current and long-term assets. The “top line” of every balance sheet is a company’s cash and cash equivalents. This is followed by their marketable securities, accounts receivable, inventory, and so on. As you can see, the assets get less liquid (or more illiquid) as you go down the list. The second part of balance sheet lists a company’s liabilities.
How to measure a company’s accounting liquidity
Simply seeing a company’s assets and current liabilities only gets you so far. To make the data useful, you have to understand how to interpret it. Accountants and financial analysts use a number of ratios to help measure the accounting liquidity. These ratios differ in how strictly they define what constitutes a liquid asset. Some of the most common are the Current Ratio, the Quick Ratio (also known as the Acid-Test Ratio) and the Cash Ratio. Let’s take a closer look at each one of these individually:
Current Ratio– the formula for the current ratio is: Current Ratio = Current Assets/Current Liabilities. So if a company has $12 million in current assets and $6 million in current liabilities, it would have a current ratio of 2. When evaluating this ratio, any number over 1 indicates a company that has enough current assets to cover its current liabilities. A number less than 1 may not mean the company cannot meet their obligations, but that they could should they run into financial difficulties.
The benefit of the current ratio for a company is that is simple and the least strict ratio. However, the ratio has certain cautions. First, by lumping all current assets into one bucket it does not distinguish between them. Some non-cash assets are more easily convertible to cash than others. For example, how quickly would they be able to collect their outstanding accounts receivables? If they are a business that carries a heavy inventory, how quickly can the inventory be sold for cash if it was needed? Also, the current ratio assumes a one-to-one correlation between assets and liabilities (i.e. that all the assets could be used to cover their liabilities. But if a business operated in that way, it would cease to be a business for long. They would need a certain amount of working capital. For all of these reasons, the current ratio is not sufficient for measuring a company’s liquidity.
Quick Ratio (Acid Test)– the formula for the quick ratio is: Quick Ratio = (Cash and Cash Equivalents + Short-Term Investments + Accounts Receivable)/Current Liabilities
Unlike the current ratio, the quick ratio only counts a company’s most liquid assets. A variation on the Quick Ratio is as follows: Quick Ratio = (Current Assets – Inventories)/Current Liabilities. By including other assets other than inventory it is a little more forgiving. Similar to the current ratio, a quick ratio of over 1 will seemingly indicate that a company has enough assets to cover its debts. In this case, however, the number may be a bit more reliable because inventory is less liquid. By the same logic, a company that has a number below 1 may be over-leveraged. It could also be experiencing declining sales, or it may be having a difficult time collecting its accounts receivable.
The benefit of the quick ratio is that it may be a more reliable indicator of a company’s ability to meet its obligations. The cautions are that it does not account for the unique business models of a company and its industry. Certain industries have certain regularly timed capital expenditures that may have a significant effect on their balance sheet. Like the current ratio, the quick ratio assumes that all the assets being measured could be used to pay off all the liabilities without taking into account a company’s need for working capital.
Cash Ratio– the formula for the cash ratio is as follows: Cash Ratio = Cash and Cash Equivalents + Marketable Securities/Current Liabilities
The benefit of this model is that it gives investors a look at a company’s worst-case scenario. That would be a situation where a company was going out of business and had to quickly turn assets into cash. The cash ratio is simple in that it is an indication of a company’s cash and near cash investments versus their liabilities. The caution for using the cash ratio is that the presence of too much cash on a company’s balance sheet can actually be seen as a negative to investors. For example, if a company has an excess of cash on their balance sheet, that cash could be given to shareholders in the form of dividends or used to buy back existing shares. So while the cash ratio may be a brutally honest way of assessing a company’s liquidity, it may have limited use as a fundamental analysis tool.
The bottom line on liquidity
One of the most important measurements of a household budget and a corporate balance sheet is the concept of liquidity. The ability to be able to pay off short- and long-term debt with cash and other assets that can be easily, and quickly, converted to cash is a way to determine that a company has an appropriate amount of revenue and that they are not overleveraged.
An important thing to remember about liquidity is that it is not just a measurement of how quickly cash can be accessed but how easily an asset can be converted into cash that reflects its market value. For this reason, cash is the most liquid of all asset classes. Securities, such as stocks and bonds are also considered reasonably liquid. Other assets such as collectibles and real estate have low liquidity.
When performing fundamental analysis of a company, a quick look at their balance sheet can be an indicator of how easily a company can pay its bills. But just looking at their current assets and liabilities is not sufficient. To get a better sense of the relationship between a company's assets and liabilities, accountants and financial professionals use one or more ratios. Three of the most common ratios are the Current Ratio, the Quick Ratio, and the Cash Ratio. Each of these ratios counts assets differently. By understanding what assets are included in each ratio, investors can draw different conclusions about the financial health of a company.