When making investment decisions, it is important to know what are liquidity and illiquidity assets. You must also know how to calculate this measurement before making your financial plan about investments and analyzing your risk. The amount of liquid assets you own is also often taken into account by lenders when granting personal or business loans. So let's understand in detail what the term means and how to measure it.

What Is Liquidity?

Liquidity, as used here, refers to a security or asset's ability to be converted into ready cash at any time without adversely affecting its market value. Cash itself is one of the most liquid assets. Due to this, the ability of a market to move efficiently is directly dependent on the availability of cash for such conversions.

A liquid asset can be converted back into cash with greater ease and efficiency. Assets that are less liquid take longer to sell and may be more expensive to buy.

A Basic Understanding of Liquidity

Liquidity can be described as the ability to purchase or sell an asset in the market quickly at a price that reflects its true value. It is universally accepted that cash is the most liquid asset since it can be converted into other assets most quickly and easily. Physical assets are generally relatively illiquid, including property, fine art, and collectibles. Equity and partnership units are also financial assets that fall in a range of liquidity levels.

Let's take an example suppose if a person wishes to buy a $1,000 refrigerator, then cash is the asset most readily available for purchasing. However, if a person does not possess cash, but does have a rare collection valued at $1,000, he or she is unlikely to find anyone willing to trade the refrigerator for the collection. They will likely have to sell the collection in order to purchase the refrigerator with the money generated from the sale.

Liquidity Has 2 Important Measurements

Liquidity can be measured in two ways, namely through accounting and market liquidity. While both methods of calculating liquidity are useful, their purposes are very different. Let's understand both:

Market Liquidity

A market's liquidity refers to how efficiently it can trade assets on various markets. The liquidity of a stock can be measured, for example, by the ease with which the stock can be bought and sold at a stable price.

A market with high liquidity allows assets to be traded, bought, and sold quickly without affecting price value significantly. The opposite is true of low-liquidity markets. As a result of this volatility, it can be challenging to sell or buy assets in these markets without causing a significant decline in the asset's price.

High-liquidity markets may be ideal if you are searching for investments that can easily be converted into cash.

Accounting Liquidity

The purpose of accounting liquidity is not to measure the efficiency of the market but to determine the ability of a company to repay its short-term debts. Liquidity ratios are calculated by comparing the company's current assets to its current liabilities. Ratios such as this provide a good indication of a company's financial health.

The company uses this measurement as a means of assessing its own financial health. As part of the decision-making process when investing or approving loans, lenders, and investors take accounting liabilities into consideration.

Liquidity Measurement Techniques

There are several techniques available for evaluating an organization's liquidity. The following are four of the most commonly used methods.

Current Ratio

The current ratio method is the simplest method for measuring liquidity. An overall financial picture of the company can be obtained from this report. It is a relatively simple formula that is derived directly from the financial statements of the company. Investing in a company with limited information will still allow you to determine its liquidity ratio.

Current ratio = liquid assets/ current liabilities

These assets and liabilities can either be converted into cash or that are due within one year.

Quick Ratio

Quick ratios are similar to current ratios, except that they only consider liquid assets like cash or cash equivalents. The purpose of this measure is to assess whether a company is financially capable of repaying existing debt.

Quick ratio = quick assets / current liabilities

Stocks, bonds, net accounts receivable, investments, cash, and cash alternatives are all considered to be quick assets.

Acid-test Ratio

There is a common misconception that the acid-test ratio is the same as the quick ratio. However, there is one significant difference between the two. This is calculated without taking into account prepaid expenses and inventories. Moreover, it gives a more comprehensive picture of the company's financial situation. As a measurement technique, this can be useful for many things, but investors may benefit from a more comprehensive analysis to determine the financial health of a company.

Acid-test ratio = current assets - inventory - prepaid expenses / current liabilities

Cash Ratio

An accurate measure of the company's creditworthiness and short-term debt repayment capacity can be determined by using its cash ratio. In emergency situations, it demonstrates the company's ability to repay its debt. In this formula, inventories, accounts receivables, cash, and cash equivalents are excluded from the calculation.

Cash ratio = cash + alternative cash flows / current liabilities

Why is Liquidity Important in Finance?

In the absence of liquid markets, it is difficult to sell assets or securities for cash or to convert securities into cash. You may own a valuable family heirloom that is valued at $150,000, for example. The value of your object will not be relevant if there is no market (i.e., there are no buyers) for it since no one will pay even close to its estimated value.

It may even be necessary to hire an auction house to act as a broker and find potential buyers, which will require additional time and cost. As a result, liquid assets may be easily, quickly, and at a reasonable cost sold for their full value.

Which Assets or Securities are Most Liquid?

Liquid assets are cash and cash equivalents, which include savings accounts, certificates of deposits (CDs), and time deposits. The exchange-listed securities, such as stocks and bonds, can often be sold quickly with a broker. Additionally, certain collectibles and gold coins can be readily sold.

Conclusion

Business owners and investors alike must understand what liquidity means and how a measure of liquidity can affect their investment decisions. By selecting liquid assets, you can make investments with the assurance that these assets can, if necessary, be converted into cash within a short timeframe.