What is Liquidity?

Liquidity is referred to as how quickly and easily you can turn an asset or security into cash without affecting its market price. Therefore, having cash on hand is crucial for making smooth and efficient market moves. Which makes cash very important when it comes to liquidity.

Synonyms

• Cash availability
• Financial flexibility
• Asset accessibility
• Cash flow
• Ease of conversion

Examples of Liquidity

Two important examples of liquidity make up the markets;

Liquid Markets

The liquid markets have many buyers and sellers, making it simple for traders to complete their trade quickly. For example, Forex is regarded as the world's largest and most liquid market, with over $5 trillion worth of trades occurring there every day.

Major stock exchanges like the New York Stock Exchange are also regarded as being extremely liquid, due to the daily exchange of thousands of shares. However, a company's market capitalization included in an index might have an impact on how liquid a stock is. Blue-chip companies like Apple, Google, and Microsoft are typically quite liquid.

Illiquid Markets

Illiquid assets are always difficult to buy or sell since there aren't enough willing buyers or sellers. Because there is comparatively less market interest, some small-cap stocks, especially those that trade over-the-counter (OTC). There may be less liquid than shares with greater market sizes.

Real estate, certain currency pairs (particularly emerging Forex pairings and exotic pairs), and smaller cryptocurrencies are some more instances of illiquid assets.

Types Of Liquidity

Here is a brief overview of the three types of liquidity.

1. Asset Liquidity

The ease with which an asset can be converted into cash without losing value is referred to as its liquidity. Because cash can be easily and quickly exchanged without losing its market value, it is the most liquid asset. Although its liquidity might be sold based on the popularity and dependability of the stock, bonds, and stocks are regarded as liquid assets.

2. Market Liquidity

Market liquidity refers to the condition in which market assets can be bought or sold. If there is a high number of buyers and sellers in the market, the liquidity will be high for the buying and selling of assets at the price you want. Meanwhile, illiquid markets are financial markets in which there are fewer buyers or sellers.

3. Accounting Liquidity

Accounting liquidity refers to the ability where companies can be able to pay off their financial obligations such as marketable securities, inventory, cash, and accounts receivable. A company's accounting liquidity is a factor that investors frequently consider when evaluating its stocks since it can provide insight into the company's financial standing.

How to Calculate Liquidity

There are various formulas for calculating liquidity that can be used to assess different aspects of the liquid situation.

1.Current Ratio

The easiest and most popular method of determining liquidity is by calculating a person's or company's current ratio. The current ratio compares the overall current liabilities of a business, such as debt commitments, to its total current assets, including non-cash assets. 

The Equation for the Current Ratio: Current ratio = Current Assets / Current Liabilities.

2. Quick Ratio

The quick ratio takes higher liquidity assets into account than the current ratio does. To calculate the quick ratio, a corporation must weigh its current liabilities against its short-term investments, cash and cash equivalents, and accounts payable.

Here is how to calculate a party’s quick ratio: Quick Ratio = (Cash and Cash Equivalents, Accounts Payable, Short-Term Investments) / Current Liabilities.

The acid-test ratio is a variation of the Quick Ratio, subtracting inventories and prepaid costs from current assets.

Here is how to calculate the Acid-Test Ratio: Acid-test Ratio = (Current Assets - Inventories - Pre-paid costs) / Current Liabilities.

3. Cash Ratio

The cash ratio is the strictest means of calculating a company's liquidity because it only accounts for the highest liquidity assets, which are cash and liquid stocks.

Here is how to calculate Cash Ratio: Cash Ratio = (Cash and Cash Equivalents, Short-Term Investments) / Current Liabilities.

Pros and Cons of Liquidity

Pros

Investors can quickly purchase and sell assets at any time during business hours if there is substantial liquidity. Given that investors can swiftly liquidate their positions without significantly affecting the asset's price, this is frequently related to lower risk. Apart from being accessible, liquid markets have higher levels of efficiency and price stability, making it simpler to trade.

Cons

Liquidity has very few disadvantages; on the contrary, the negative effects of insufficient liquidity, or "liquidity risk," are usually worse.

There may be large and frequent price movements in an illiquid market since there is little supply and demand for the traded security. It is possible for buyers and sellers to have to deal with several individuals, at varying costs, before their order is filled to the desired size.