What is liquidity?
Liquidity refers to how quickly and easily assets can be converted to cash.
An asset is liquid if it can be:
- Easily exchanged
- Quickly exchanged
- Exchanged at little or no cost
Cash is the most liquid asset because it can be easily converted into other assets; for example, if someone wants to buy a $500 television, that person could easily pay for it in cash. It would be much harder, however, to use an antique that’s worth $500 to trade for the television because not many people would want to trade a television for an antique. Instead, the antique owner must sell the antique and then use that money to buy the television, which is a much longer and more difficult process.
Calculator: Who wants to be a millionaire?
Examples of non-liquid assets
- Real Estate
- Coin Collection
- Wine Collection
Liquidity measures both the number of buyers and sellers as well as the demand for the asset. An asset may have a high demand but low liquidity if buyers and sellers disagree on the value. On the other hand, everyone may agree on the price of an asset, but there may be few buyers or sellers.
An important component of this is the speed that you perform a transaction—the shorter the time between when you put up a share as a seller to when you find a buyer, the more liquid the stock.
If you’re investing in smaller companies, it’s important to remember that your ability to buy/sell stock will be limited by the number of buyers/sellers and can be more illiquid than the stock of larger companies.
This is the measure of someone’s ability to have access to their money as they need it. To measure accounting liquidity, you have to compare liquid assets with current liabilities, which can be done through different ratio tests.
|Current Ratio||Current Assets / Current Liabilities||Simplest and least strict ratio; current assets can be converted to cash within a year|
|Acid Test or Quick Ratio||(Cash + Short-Term Investments + Accounts Receivable) / Current Liabilities||Excludes inventories and other current assets, which aren’t as liquid as cash, accounts receivable, and short-term investments|
|Cash Ratio||(Cash + Short-Term Investments) / Current Liabilities||Most challenging; evaluates an entity’s ability to stay liquid in case of an emergency|