What Is Liquidity? Practical Examples and Real-World Applications

What is liquidity?

When an asset (money, stocks, real estate, cryptocurrency, etc.) can turn into cash quickly without a significant change in price, this is called liquidity. The higher the liquidity, the easier it is to sell the asset for its market price. For example, land, collectibles or real estate are much less liquid than cash and cash equivalents.

Types of liquidity

There are different types of liquidity. Each corresponds to liquidity on different levels and all of them are essential to building a strong investing strategy.

Market liquidity

Market liquidity refers to how easily you can buy or sell an asset easily without a significant price change. If market liquidity is high, it is easy to quickly find a buyer or seller at the market price. For example, stocks of large companies, currencies, cryptocurrencies and government bonds are quite liquid because people trade them frequently. Relatively rarely traded assets like real estate or rare collectibles are much less liquid: it may take months to sell a house or a rare painting, and the price can fluctuate a lot.

Accounting liquidity

When a company can pay its short-term debts (loans, bills) with liquid assets such as cash, accounts receivable, and other short-term assets, that is called accounting liquidity.

As mentioned above, long-term investments and real estate are less liquid.

Asset-level liquidity

When we talk of a particular asset, an important factor is its asset-level liquidity. If you can convert an individual asset into cash with minimal loss in value, then it is liquid (e.g. cash, large company stocks, government bonds). Land, equipment, and collectibles have low liquidity.

Portfolio-level liquidity

Another liquidity type is portfolio-level liquidity. This is essentially the same concept as asset-level liquidity, but it refers to a portfolio as a whole: namely, how quickly you can sell it without losses. You can easily convert a portfolio of liquid assets like stocks or bonds into money, but a portfolio that includes long-term investments or rare assets is difficult to sell quickly.

Different liquidity requirements across various sectors of the economy

Different industries and sectors have varying liquidity needs, based on how quickly they need access to cash. These requirements depend on the specific nature, needs and goals of the industry.

For example:

• Retail businesses need high liquidity to pay suppliers and manage daily operations.

• The same goes for banking organizations and financial institutions: they must maintain high liquidity to respond quickly to customer demands, fulfill daily operations, and cover liabilities.

• Construction companies may work with less liquid assets like land and long-term projects.

• Tech startups may have lower liquidity but rely on long-term investments to grow.

Measurement methods

There are three main methods of measuring liquidity and assessing a company's ability to meet its short-term obligations.

Current ratio: calculations and examples

Current ratio evaluates a company’s ability to pay its short-term liabilities (debts due within a year) using its short-term assets. The formula is:

For example, if a company has $100 000 worth of assets ($50 000 in cash, $30 000 in accounts receivable, and $20 000 in inventory) and $70 000 of liabilities ($40 000 in accounts payable plus $30 000 of short-term debt), its current ratio according to the formula is 1.43. That means that for every $1 in liabilities, the company has $1.43 in assets — enough money to cover its debts. A ratio above 1 is generally considered quite healthy (but more precise interpretation depends on the industry).

Quick ratio (acid-test ratio): calculations and examples

Quick ratio (also called acid-test ratio) measures the company’s ability to pay its debts using its highly liquid assets, but not all its assets. That makes this measurement even more accurate than the current ratio. The term ‘acid test’ refers to a quick test that provides instant results.

The formula goes like this:

Suppose a company has $70 000 of liabilities at the moment, $100 000 in all assets, and $20 000 of them is inventory. In that case, the quick ratio is 1.14 — again, it is enough to easily meet liabilities without selling your lower-liquidity assets.

Cash ratio: calculations and examples

This is the most accurate measure of liquidity. It shows whether a company has enough cash and cash equivalents (e.g. treasury bills) to pay off its short-term debts. The formula is:

A company that owns only $50 000 in cash and owes $70 000, has a cash ratio of 0.71, which is not very healthy: it is not enough cash to cover all of its debts easily (the ratio is less than 1).

These ratios help to understand how easily a company can pay off its debts in the short term and what kind of assets it can or should use to do so. Each ratio highlights different aspects of liquidity, helping businesses and investors make informed decisions.

Ranking market liquidity

We can divide all types of assets into three broad categories based on their liquidity.

High liquidity:

• Cash and cash equivalents: the most liquid asset, because you don’t need to convert it to use it. Also there is no risk of losing value when it is used.

• Stocks of large companies like Apple or Amazon — you can usually trade them easily on the stock exchange because buyers and sellers are almost always available.

• You can also quickly sell government bonds on the market, since they are bonds issued by stable governments (e.g. U.S. Treasury bonds). Investors often consider them safe havens in financial markets, and they are widely traded and trusted.

Medium liquidity:

• Corporate bonds are less liquid than government bonds because there is lower demand for them. Liquidity also depends on the company’s creditworthiness and market conditions. For instance, bonds from an S&P 500 company are relatively easy to sell, but those from smaller companies might take more time.

• Small-cap or less popular stocks can be harder to sell because fewer people trade them.

• Commodities’ liquidity varies depending on the market's activity. Commodities like gold or silver are more liquid, while physical commodities like oil require additional logistics and paperwork, which lowers their liquidity.

Low liquidity:

• Real estate or collectibles: real estate transactions require time to find buyers, negotiate prices, and complete paperwork. Sometimes you will have to drop the price significantly to close the deal quickly, and prices can fluctuate significantly based on market conditions and location. Rare collectibles like an authentic work by Picasso can take time to find a buyer and agree on a price.

• In the case of private equity and venture capital investments, it is harder to find a buyer. These investments are in privately held companies and there’s no public market for quick trading.

Key factor: asset liquidity depends on trading volume, market depth, market transparency, and the spread between the buy and sell price. The faster a transaction can be made, the higher the liquidity of the asset.

Impact of liquidity

Liquidity plays an important role for individual investors, companies, industries, governments and for the economy as a whole.

For example, an individual might need to sell their car quickly to pay an emergency bill (asset-level liquidity). A company makes sure it can pay employees on time (accounting liquidity). A government manages cash reserves during an economic downturn to fund public services (market and sector-level liquidity).

Here are the main aspects that liquidity can influence.

Asset prices

Assets with high liquidity, such as stocks of large companies or popular cryptocurrencies, tend to have more stable prices. Due to high trading volume, the price of an asset changes slowly and you can usually sell or buy it at a price close to the market price.

By contrast, assets with low liquidity (e.g. real estate or rare cryptocurrencies) can fluctuate greatly in price due to the limited number of buyers or sellers.

Risks

High liquidity also reduces risks. If you buy or sell easily then you can be sure that you won’t lose significantly when market conditions change.

However, low liquidity increases risks: when an asset being held for a long time becomes problematic, investors may face large losses, especially during market volatility if an asset takes time to sell.

Investing abilities

With high liquidity comes greater flexibility. It is easy to enter and exit trades, allowing them to react quickly to market changes and adjust investment strategies (which also reduces risks).

Owning a lot of illiquid assets can limit your ability to invest. You may be unable to sell assets quickly when you need to, and miss out on the opportunity to take advantage of more favorable market conditions.

Financial stability

High liquidity contributes to the stability of the financial system as a whole. It supports a healthy economy and reduces the risk of economic crises. But when assets cannot be sold quickly, it can lead to a lack of liquidity in the market and cause economic problems and instability.

Credit availability

High liquidity facilitates access to credit. When banks and financial institutions can sell assets quickly or provide liquidity, they are willing to lend and borrow. However, when assets or securities are difficult to sell, lending can be limited because financial institutions will be less willing to lend.

Summary

Liquidity is crucial to financial stability. It influences decisions at every level, from individuals managing personal finances, to businesses and investors navigating markets. By understanding different types of liquidity, and how it is measured, a person or a company can make informed decisions to optimize resources, reduce risks, and make the most of opportunities.