When you start investing, you will quickly come across the concept of ‘liquidity’. But what exactly does liquidity mean, and why is it so important for you as an investor? In this module, you’ll discover everything about liquidity, its role in investing, and how you can calculate it.
What is meant by liquidity?
Liquidity in investing refers to the extent to which you can convert a financial product into cash without it losing much value. The easier and faster you can sell something, the higher the liquidity. An example of a liquid investment is a stock, because it is relatively easy to trade.
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3 types of liquidity
Liquidity plays an important role in investing. Different assets, markets, and investment products vary in liquidity. Let’s have a look at this so you can better understand how it works.
1. Assets
When we talk about the liquidity of assets, we refer to how quickly you can buy or sell them at a price close to market value. Cash is the most liquid, as it is immediately available for use. Real estate and artworks are less liquid, as it usually takes more time to find a buyer.
Stocks and bonds are relatively liquid. However, there is a difference in the degree of liquidity. Large publicly traded companies with a high market capitalisation (the total value of outstanding stocks) usually have higher liquidity than smaller companies traded on smaller exchanges.
2. Market
The liquidity of a market indicates how easy it is to buy or sell assets for a fair price. The stock market, for example, is a liquid market because millions of company stocks are traded daily. This ensures a constant flow of buyers and sellers.
With stocks, liquidity is usually reflected in the bid and ask prices (the highest price a buyer wants to pay and the lowest price a seller wants to receive). A wide difference between these prices (high spread) can indicate low liquidity.
3. Accounting
In accounting, liquidity refers to the extent to which a company is able to meet short-term payment obligations, such as a debt, with current assets. This is an important measure of a company’s financial health.
A company’s assets are listed on the balance sheet, from most to least liquid. A company must have sufficient liquid assets to meet these financial obligations, otherwise, this can lead to financial problems.
Why is liquidity important?
In investing, liquidity is important regarding speed, price certainty, and transaction costs. For example, if you want to sell a stock or ETF and liquidity is high, you can sell the investment product quickly for the market price. Is the liquidity low? Then it might take longer to sell the investment product, or you might get a lower price for it.
Additionally, low liquidity often causes a wider bid and ask price. This means you pay more when buying and get less back when selling. For investors who trade frequently or with larger investments, this difference can be significant. This can result in lower returns.
The liquidity of companies is also important. Investors include this in their analysis to decide whether it is smart to buy that stock. If a company has low liquidity, an investor might have less confidence and not buy the stock.
The benefits of good liquidity
The benefit of good liquidity is that you can usually convert investments into cash quickly and without major price fluctuations. Moreover, it is possible to respond quickly to market opportunities or unexpected financial situations. You are not stuck in your position, which increases your flexibility and reduces the risk of being forced to sell your investment at a less favourable price. Additionally, liquidity contributes to more efficient pricing because there are more active buyers and sellers.
Calculating liquidity: how do you do it?
In investing, it is important to have insight into a company’s liquidity. To assess whether a company is liquid, investors use various liquidity ratios. Below we explain the most commonly used ratios, namely:
- current ratio;
- quick ratio;
- cash ratio.
Current ratio
The current ratio indicates the extent to which a company can pay off debts in the short term with current assets (resources that can be converted into money quickly within one year). This is the formula:
Current ratio = current assets / current liabilities
An example
A company has €200,000 in current assets and €100,000 in current liabilities. The current ratio is then 200,000 / 100,000 = 2. This means that the company has twice as many liquid assets as it has to pay in the short term. There is healthy liquidity.
Quick ratio
The quick ratio is a strict measure to determine liquidity. With the quick ratio, you do not include inventory, because you can usually convert this into money less quickly. This is the formula:
Quick ratio = (current assets – inventory) / current liabilities
An example
A company has €400,000 in liquid assets, €50,000 in inventory, and €200,000 in current payment obligations. The quick ratio is then (400,000 – 50,000) / 200,000 = 1.75. This means the company can meet its short-term payment obligations.
Cash ratio
Finally, the cash ratio. The cash ratio shows whether a company can meet short-term debts with only cash and cash equivalents. This is the formula:
Cash ratio = (cash + cash equivalents) / current liabilities
An example
A company has €150,000 in cash and cash equivalents and €100,000 in current liabilities. The cash ratio is (150,000) / (100,000) = 1.5. The company can cover the short-term debts with cash and cash equivalents.
What is healthy liquidity?
What constitutes healthy liquidity varies per company. Generally, you can assume that a ratio above 1 is financially healthy. That is to say, if the incoming cash flow is higher than the outgoing cash flow. You can then include this assessment in your choice to invest in a company’s stocks. But note, it is a snapshot of a certain period. So ensure you calculate liquidity over the longer term to keep track of developments.
Liquidity risk
Liquidity risk is something every investor can face. Not all assets are equally liquid. Generally, the rule applies: the more liquid assets are, the less risky they are. When we talk about liquidity, stocks are generally easier to buy or sell, while an antique painting can be more difficult.
Liquidity risk can also arise if a company cannot meet short-term obligations. This can impact the price of stocks and thus your investments. It is therefore important to be aware of this risk.
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All views, opinions, and analyses in this article should not be read as personal investment advice. Individual investors should make their own decisions or seek independent advice. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication.
