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Financial liquidity is the ease at which an asset can be converted into cash. Conversely, an asset that is considered illiquid cannot be easily converted into cash or is difficult to trade.
What is financial liquidity and why is it important?
For businesses, liquidity is a critical component of corporate risk assessment and indicates to investors how much cash is on hand to cover short-term debt and other obligations. For instance, a company requires liquid assets to pay interest on its debt and pay dividends to shareholders. Plus, liquid assets are often required to help grow a company. Payroll, rent and other operating expenses also typically require liquid assets.
On a personal finance level, you’ll need liquid assets to cover regular expenses or to fund a non-financed down payment on an asset such as a house or car. And, some real estate transactions, such as buying into a co-op or condo building, require a certain amount of liquid assets to prove you have the funds to pay the maintenance or homeowner association fees. Beyond that, you need some easily accessible cash to cover bills, debts and emergencies.
Examples of liquid assets
Cash is the most liquid asset, followed by cash equivalents such as Treasury bills, Treasury notes and certificates of deposit (CDs) with a maturity of three months or less. A CD with a longer timeline than three months can still be considered liquid if you’re willing to pay the penalty to access the funds before the maturity date. Other assets considered liquid are checking accounts, savings accounts, money market accounts and cash management accounts.
What about your brokerage account? Well, marketable securities such as stocks, bonds, ETFs and mutual funds are typically considered liquid because they can often be sold or traded quickly. That said, securities are considered less liquid than actual cash as sometimes it takes three to five days for a trade to settle and for the cash proceeds to hit your account. Securities markets can be volatile and you may not be able to sell at the price you want, when you want.
Examples of less-liquid assets
The least liquid assets typically take the longest time to sell. Houses, land and other real estate fall into this category of assets. You can turn these investments into cash, but the process can take months or years and usually involves a number of other costs such as realtor commissions and closing costs.
Other examples of illiquid assets include fine art, collectibles, jewelry, private company interests and cars. For businesses, equipment and inventory are illiquid. Think of it this way: If you have to find a buyer, and the item is unique and/or of high value, it’s likely less liquid.
Think of liquidity as a scale, not as an absolute category. For example, crypto is considered liquid, but it’s less liquid than cash because of the time it takes to turn cryptocurrency into cash.
How to measure financial liquidity
You can measure financial liquidity with a handful of different ratios. Investors and creditors use these ratios to determine if a company can cover its short-term obligations and to what extent. Lenders can also use these ratios to help determine creditworthiness.
Here are the most common ones:
Current ratio: Also known as the capital ratio, the current ratio is calculated by dividing its current assets by its current liabilities — two figures found on a company’s balance sheet. If the ratio is one, the company can cover its liabilities exactly. Anything under one means the company’s current liabilities exceed its current assets.
Here’s the formula:
Current ratio = Current assets / Current liabilities
Quick ratio: Sometimes called the acid-test ratio, the quick ratio is identical to the current ratio but excludes less liquid assets such as inventory and prepaid expenses. You’d use this formula to find a more exact measure of a company’s ability to pay its obligations. For instance, a quick ratio of less than one indicates bankruptcy risk. If a company’s creditors all call in their loans, there’s not enough cash to cover. The quick ratio is a more conservative application of the current ratio.
Quick ratio = (Cash and cash equivalents + Accounts receivable + Marketable securities) / Current liabilities
Cash ratio: The most conservative of these three ratios, the cash ratio is calculated by dividing cash plus cash equivalents by the current liabilities. Companies with higher overhead and money tied up in long-term investments will often have a lower ratio than a company with a lot of cash and cash equivalents.
Cash ratio = Cash and cash equivalents / Current liabilities
What is liquidity risk?
Liquidity risk happens when you can’t sell an asset quickly enough to pay your debts. For example, if a company needs to carry out a large purchase within 30 days, but most of its assets are tied up in long-term investments, the company would have liquidity risk.
For an individual, this could mean owning a house outright but not having the cash to cover utility bills and student loan payments. If your only assets are your house and car — both illiquid assets — you have liquidity risk.
Financial liquidity vs. solvency
Financial liquidity refers to a business’s ability to meet its short-term obligations, while solvency refers to a business’s ability to pay off its long-term debts and obligations. A company can be solvent, yet have low liquidity. An example is a company with a large inventory and overhead, such as a factory, with plenty of sales and incoming orders, but no cash on hand. This could happen if a business uses profits to buy more raw materials or real estate.
Advantages of financial liquidity
Some of the advantages of cash and cash equivalents include:
- Less risk of bankruptcy.
- Higher access to credit.
- Lower volatility.
- Fewer taxes relative to interest earned because liquid assets generally have lower yields.
- More flexibility.
Disadvantages of financial liquidity
While liquidity is important, there are some downsides to keeping a surplus of cash assets including:
- Lower interest rates earned on cash.
- Loss of buying power over time if returns trail inflation.
Bottom line
Analyzing liquidity helps you understand the financial health of a business. While it’s not the only number you’ll need, liquidity ratios clue you into a company’s ability to cover short-term debts and expenses.
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