The meaning of liquidity can vary slightly depending on the context in which it is used. However, it always has to do with how fast and how easily security or financial assets can be converted to cash without losing value. One way to look at liquidity is how long it takes to sell an asset for cash.
Liquidity is important to a company because it demonstrates how flexible a company can be when it comes to meeting financial obligations, as well as unexpected costs. However, liquidity can also apply to individuals. For example, the greater an individual’s liquid assets are when compared to their debts, the better their financial position. Why? Because they can easily have cash on hand if needed to cover expenses,
There are several types of liquidity, but only two basic forms, which include market liquidity and accounting liquidity. Market liquidity applies to assets and investments. Accounting liquidity applies to personal or corporate finances.
What is Liquidity?
Liquidity is being able to turn assets into cash. Assets are considered to be liquid if they can be purchased or sold quickly without affecting its price. An asset is highly liquid if it can be sold quickly for its full value. Assets are considered to be less liquid or illiquid if it takes a long time to sell them or if they can’t be sold for full value. There are two types of liquidity: market and accounting. They are related but refer to different concepts. Market liquidity refers to stock trades in publicly traded markets. Accounting liquidity is how easily a company can pay off its short-term debts or obligations.
Why is Liquidity Important?
Liquidity is important to a business for several reasons. Businesses take stock of their liquidity regularly because of its importance. Liquidity is one way to track a business’s financial health. It needs to have enough cash available to meet its financial obligations. However, holding onto too much cash can often mean leaving important growth and investment opportunities on the table. By measuring liquidity, a business can find the right balance, monitor the company’s financial health, and position itself for strategic growth. Investors and banks consider the liquidity ratios to determine if the company has the ability to pay off debt. And finally, understanding your company’s liquidity allows it to use it as a benchmark against other companies in the same industry.
What is the most Liquid Asset?
Actual cash on hand is the most liquid asset. Second, cash is funds that can be easily withdrawn from a bank account. A business or individual can own numerous valuable assets. But there’s an old expression; cash is the king that applies to liquidity as well.
What are the types of Liquidity?
Here are the different types of liquidity.
| Liquidity Type | Description |
| Market Liquidity | Market liquidity refers to marketable assets which are purchased and sold. Examples include the stock market and real estate market. |
| Accounting Liquidity | Accounting liquidity measures how easily a company or individual can meet its financial obligations with available liquid assets. |
1. Market Liquidity
Market liquidity refers to the conditions of a market where assets are purchased and sold. Markets have higher liquidity because it is easy to buy or sell assets at the desired price. Examples include a country’s stock market and a city’s real estate market. Both of these examples are setting that allow assets to be purchased or sold at stable, open prices.
2. Accounting Liquidity
Accounting liquidity is the ability a company or individual has to use assets to pay off their financial obligations. Cash can be obtained through marketable securities, cash on hand, accounts receivable, and inventory, for example. Investors look at a company’s stocks to measure its accounting liquidity since it conveys the state of the company’s financial health.
How to Measure Liquidity
A company’s liquidity refers to its ability to use current assets to meet short-term liabilities. Liquidity is measured by how much cash the company can generate above and beyond its current liabilities. There are three ratios used to measure the liquidity of a company. The first measure is the current ratio, which is also known as a working capital ratio. This ratio measures the liquidity of a company, and the formula is current ratio= Current Assets/Current Liabilities. The second ratio used for measuring liquidity is the Acid-test ratio. The formula for this quick ratio is Acid-Test Ratio=Cash+short-term investments+accounts receivable/current liabilities. This ratio excludes illiquid assets. The third ratio used to measure liquidity is the Cash Ratio. The cash ratio formula is cash+short-term investments/current liabilities. This ratio provides insight into how well a company could pay off debts if there were an emergency.
How can Liquidity be Improved?
If a company’s liquidity is too low, there are ways to make improvements. Here are five ways a company can improve its liquidity.
- Control Overhead Expenses. Find ways to reduce daily operational costs. A company can also improve efficiency, which saves time and money.
- Sell off Unneeded Assets. Eliminate surplus items like unused business equipment. This provides capital and reduces the cost of equipment maintenance.
- Change Payment Cycles. Vendors often offer discounts for early payment. Companies can also provide discounts for its customers or clients who pay ahead of schedule.
- New Line of Credit. A new line of credit regularly helps cover cash flow gaps. This is a temporary fix to help free up other funds, which improves liquidity.
- Recalculate Debt Obligations. Consider the short and long-term debts the company owes. Changing short-term loans to long-term debts can help improve liquidity.
Control Overhead Expenses
Conducting an audit of the company’s expenses can help find areas that can be improved. Find ways the company is using time and energy, then determine how processes and procedures can be improved to reduce expenses. For example, switching to digital checks rather than paper payment options can save both time and money. Also, look for ways to reduce operational costs, such as utility bills, insurance, and rent.
Sell Unneeded or Unused Assets
If a company is just storing unused or unproductive assets, they can be sold. The only reason a company should spend money on assets like equipment, vehicles, and buildings is to generate more revenue. If items are not generating revenue, sell them to increase cash on hand.
Change Payment Cycles
Accounts receivable should be monitored closely to ensure clients are being billed properly and in a timely fashion. It’s also important to know if the company is receiving prompt payments. Negotiating with vendors for discounts for paying early can help reduce payload. Another option is to negotiate longer payment terms with vendors, which keeps money on hand longer.
New Line of Credit
Opening a new line of credit can help cover financial gaps in a company’s cash flow because of payment schedules. Some lenders offer businesses lines of credit for up to $100,000 per year without an annual fee, at least for the first year. Make sure to compare terms before choosing a lender. Transferring short-term debts into long-term debts can improve liquidity.
Recalculate Debt Obligations
Switching short-term debt obligations to long-term loans can decrease monthly payment obligations. It also provides more time to pay off the debt. Consider other options like loan refinancing or debt consolidations, which may help save money in the long run while lowering current monthly payments.
What is the Liquidity Ratio?
Ratio analysis uses a series of equations to calculate a company’s solvency. Liquidity ratios compare assets against liabilities. There are three types of liquidity ratios. The current ratio is a simple calculation that compares total current assets against total current liabilities. The quick liquidity ratio considers higher liquidity assets than the current ratio. The quick ratio compares the company’s cash, short-term investments, and accounts payable against current liabilities. The third liquidity ratio is the cash ratio, which is the strictest means to measure a company’s liquidity. It directly compares the company’s cash and short-term investments to its current liabilities.
What is Liquidity Risk?
Liquidity is the ability of a business or individual to pay debts without suffering extreme losses. Investments and other assets need to be sold quickly to help minimize loss. Liquidity risk is when an investment cannot be purchased or sold quickly due to the lack of marketability. There are two types of liquidity risks. The first is where there are too few buyers to sell off assets. The other type is when cash flow is running short. For example, stocks or real estate may be valuable, but it may be difficult to sell them off fast enough to obtain the cash needed. Another liquidity risk is a portfolio that is not balanced.
What are Liquidity Requirements?
Liquidity requirements for financial institutions mean that they must hold onto enough high-quality liquid assets to cover their cash outflow for at least 30 days. The liquidity coverage ratio (LCR) is the proportion of highly liquid assets being held by financial institutions. The LCR ensures the institution has accessible liquid assets that can meet its ongoing short-term obligations.
What is Financial Liquidity?
Financial liquidity is how quickly and easily assets can be converted to cash. Inventory, cash, public stock, and some receivables are thought to be more liquid since companies or individuals can count on them being converted to cash in a short time. Private securities and long-term fixed assets are more difficult to sell, so they are illiquid. Companies can calculate their current ratio to gauge their liquidity. Liquidity is important because it is an indicator of whether a company has the ability to satisfy its debts.
Is Liquidity Required for a Company?
No. Liquidity for most companies is not a requirement as much as a calculation. However, a company’s liquidity can be an indicator of the level of success it can expect. Liquidity is often a factor used by investors and lenders as to whether a company is worth its investments. Banks, on the other hand, do have liquidity requirements to help reduce the impact of a negative financial crisis.
