What is Liquidity?

Fundamentals · Aug 2, 2019

Liquidity is a core concept in finance, capital management, and business and that’s why this term is often used in media by portfolio managers, market analysts, and various economists. Although this term is very popular, it’s not that easy for an outsider to understand what it means.

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In this article, we’ll try to explain the concept of liquidity using simple terms and analogies.

Definition of Liquidity

The word “liquidity” comes from the word “liquid” and suggests that it’s something very flexible and that it can easily change its form. Market liquidity shows us how easy is it to convert a certain asset (stock, market security, bond, property or another type of asset) to the most liquid type of asset: cash.

Understanding Liquidity

The idea behind the concept of liquidity is that cash (any legitimate currency) is fully liquid (liquidity = 1 or 100%) because it’s the basis of money measurement and because it’s accepted everywhere and by everyone. Any other asset has a value which is measured in cash and it can be exchanged for it, so the liquidity means two things:

  • How easy is it to sell this asset, is it even possible and how long would it take?
  • Can it be sold for its fare value or is it going to be discounted?

These two factors are usually codependent to a certain degree: if it’s not possible to sell something, that probably means that the price is too high and as soon as the price is lowered, the liquidity would go up.

Therefore, a liquid asset is something that is desired and that has a high demand.

What is an Illiquid Asset?

An asset can be called “non-liquid” or “illiquid” (with low liquidity) if it’s hard to find a buyer for it or if it takes a lot of time to arrange a transaction. Sometimes it’s possible to sell an asset at its fair price but it’s not easy to find a buyer quickly enough.

➤ Read also: What are Assets?

In this case, the asset would still be considered illiquid because time matters a lot. A perfectly liquid asset can be exchanged to cash at any moment without the need to discount its price. Certain assets are not liquid at all so it’s impossible to liquidate (sell) them. Technically speaking, they can’t be called “assets” anymore and they might become liabilities.

Asset Types by Liquidity

Here are some examples of highly liquid, somewhat liquid and illiquid assets:

  • Cash - perfectly liquid by definition
  • Marketable securities - can be sold pretty quick but may need a few hours or days to be converted to cash under certain conditions
  • Accounts receivable - can’t be converted to cash immediately
  • Inventory - it’s hard or even impossible to sell it quickly at a fair price
  • Fixed assets - includes property, equipment, furniture, vehicles and so on, may take a long time to find a buyer
  • Goodwill - can be converted to cash only when the whole business is sold

How to Use Liquidity and Why is it Important?

Liquidity can be useful in the company’s analysis, especially for asset evaluation. One example of the use of liquidity is the quick ratio, which serves exactly this purpose: to analyze a firm’s short-term liquidity risks by taking into account only the most liquid types of assets that the company has.

There is no official mathematical formula to calculate liquidity, but there are some ratios and indicators which measure liquidity, such as the Liquidity Ratio, the quick ratio and the current ratio (to some degree).

When it comes to financial markets, liquidity is used to evaluate traded assets like stocks, bonds or ETFs in a slightly different sense. In this case, liquidity often means that a particular asset is historically stable and that it was exchanged for cash a significant number of times. Those are so-called blue-chip stocks and global currencies (US dollar, Japanese Yen and Euro). If an asset has been traded for a long period of time, it’s usually a positive sign because it tells investors and portfolio managers that this asset is proven to have no cash conversion problem.

Determining asset’s liquidity is critical no matter whether it’s a publicly-traded market asset or an asset owned by a company (particularly in banking). The misjudgment of an asset’s liquidity leads to a vulnerable position in an unfortunate situation when it has to be sold promptly.

Bitcoin Liquidity

Liquidity applies to any type of asset (even old home furniture or a car) including Bitcoin and other cryptocurrencies. The liquidity of cryptocurrencies is the key issue with this new technology and it demonstrates the concept of liquidity in a clear way.

For a currency to be liquid, it has to be accepted by all major economies, institutions and by a large number of individuals. Bitcoin occupies an interesting grey spot between a super-liquid assets (because it’s trying to present itself as any other currency) and as a totally non-liquid fake or fraud money. From the technical point of view, Bitcoin is perfectly liquid, it can be exchanged for cash in a second as long as there is a buyer, but the main problem is the price at which this deal can be accepted.

Unlike many other assets where the liquidity is sort of fixed and known, Bitcoin liquidity has been changing over time. When a country bans a cryptocurrency its liquidity falls down, but when news came out that a new company accepts it as a payment for its goods and services, its liquidity rises. Bitcoin’s price is mainly based on its liquidity and on a distrust of the traditional financial institutions.

Liquidity and Price

Liquidity often works as a price multiplier in a strange way and its easy to explain if you imagine an asset, even a totally useless one, with 100% liquidity. Imagine an asset that is not cash, but which can always be converted to cash at its initial value. Therefore, this asset can be used as cash and it works as a cash replacement. With this idea in mind, you can see how an increase in liquidity can lead to a rise in an asset’s price.

The opposite is true as well, if a government institution bans a publicly-traded stock from the market, or if they launch an investigation against a company, the price of that stock will go down only because the perception of its liquidity changes so the market doesn’t feel that this stock will be easy to buy or sell in the future. The perception of liquidity plays an important role in the psychological behavior of investors, therefore it has a major influence on market prices.

trading   investing   analytics   finance   business   capital   market   money   portfolio   liquidity

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