What is Liquidity?

What is Liquidity

Liquidity describes the ease at which you can buy or sell assets without impacting their price. When it comes to stock markets, market liquidity helps us understand why stocks can trade hands so quickly, as well as why buying large volumes of a stock doesn’t result in crazy price swings. Likewise, when it comes to analyzing companies, accounting liquidity helps investors understand how well a company could fare if it had to use cash on-hand to cover short-term debts.  

Below, we’ll teach you everything you should know about liquidity, both market and accounting liquidity, as well as some ways you can measure both types. 

What is liquidity? 

An asset is heavily liquid when you can buy or sell it without impacting its price. Conversely, when an asset requires you to adjust the price—typically lowering it—it’s considered to be less liquid or even illiquid. 

As a basic example, let’s say you want to buy a new couch that costs $2,500. In this scenario, the most liquid asset you can use to buy that couch is cash. If you have $2,500 in cash, you can exchange it for the couch without necessarily adjusting the price (in this case, possibly going higher). 

But let’s say you didn’t have cash. Let’s say, instead, you have a collection of rare coins that are appraised at $2,500. You take your collection of coins to the couch retailer and offer them as payment. As expected, the retailer doesn’t want your coins; they want $2,500 in cash.

Now, you have to sell your coins for $2,500. If those coins were in high demand, that is, if swathes of consumers wanted to pay $2,500 for them right now, we could call them liquid.

On the other hand, if you can’t find a buyer, if you have to reduce the price of your coins to attract one, then we’d call those coins illiquid. 

Market liquidity versus accounting liquidity 

When it comes to liquidity, you’ll encounter two types: accounting and marketing liquidity. Market liquidity refers to a stock’s ability to buy or sell for its asking price. When large volumes of a certain stock trade per day, when the asking price doesn’t differ much from the price at which it’s sold, we’d call that stock heavily liquid.

Accounting liquidity, on the other hand, refers to a company’s ability to convert its assets into cash, whether that’s inventory or accounts receivable, as well as the cash it has on hand. When a company is highly liquid, it typically has the cash to meet its financial obligations, such as pay its debts, though it might not be investing that cash in growth and expansion. 

How can you measure market liquidity?

You can measure a stock’s liquidity by looking at the difference between a stock’s asking price and the price at which it finally sells (or the “bid-ask spread”). If the difference between the two is insignificant, then the stock is considered fairly liquid. 

For example, let’s say you were considering buying shares of a hypothetical stock, call it, Stock A. If the asking price of Stock A is $89.89, and the final price was $89.895, then Stock A would be a highly liquid stock: the difference in this scenario is insignificant. 

Another way to examine a stock’s liquidity is to look at its trading volume. When a stock trades heavily, it’s fairly easy to buy or sell it at its asking price, and we would say the stock is liquid. Typically, a trading volume of one million shares per day is considered a good sign of high liquidity. 

How can you measure accounting liquidity? 

For investors who want to analyze a company’s finances more deeply, accounting liquidity can help you see how quickly a company can convert assets into cash. This is important because, unless a company has the cash to meet short-term financial obligations, it won’t likely be successful over the long-run. 

To understand how liquid a company is, here are a few metrics you can use. 

  • Current ratio: Here, current refers to the next twelve months, and current ratio compares current assets (assets the company can convert into cash quickly along with inventory and supplies) with current liabilities (debts to be paid in the next year). A current ratio of 1.5 or higher suggests greater liquidity, while a current ratio of 1 or lower might indicate the company is illiquid. 
  • Quick ratio: The quick ratio measures a company’s ability to convert assets quickly (like, if they had to do it today) in order to meet short-term financial obligations. To get the ratio, add together a company’s cash, its accounts receivable, and its market securities (stock, bonds, GICs), then divide that sum by its current liabilities. The higher the ratio, the more liquid the company’s assets. 
  • Cash ratio: Finally, you can measure a company’s liquidity by dividing how much cash it has on hand with its current liabilities. Again, the more cash the company has, the higher the ratio, and the more liquid the company is.

Which stocks are the most liquid? 

Perhaps the stock with the most liquidity is large-cap stocks (or even mega-cap stocks). Because large-cap companies are well-established and popular household names, their stocks trade frequently. For example, if you wanted to buy five shares of Shopify (TSX: SHOP) right now, you could easily get those five shares: you just place an order with your broker, and, in a short period of time, the shares end up in your account. What’s more, you’ll most likely buy the shares at the asking price. 

Below large-cap stocks, mid-caps are also fairly liquid, though it depends entirely on the company. After mid-caps, stocks with lower market capitalizations, such as small-caps and micro-caps, will have less liquidity. That’s not to say you won’t find a buyer for these types of stock (or a seller if you want to buy them). But it might be more difficult, especially if you’re trying to trade large shares. 

Foolish bottom line on liquidity 

Both market and accounting liquidity are important for investors. When a stock is heavily liquid, you can buy or sell it without impacting its price. The heavy trading volume ensures the asking price differs insignificantly from the final price, which means you won’t lose money just by conducting a trade. 

Of course, for a stock to trade at such high volumes, the company itself should have financial stability. One way to measure that stability is to examine its accounting liquidity, how its current assets compare to its current liabilities. Companies with higher liquidity aren’t as threatened by short-term debts as those with less cash on hand.

Finally, liquidity is important because it tells you how easily you can convert your portfolio into cash, should you need. If your storks are heavily liquid, you don’t have to worry so much about selling them when the time is right. A liquid portfolio is ideal for investors who want to sell stocks to generate retirement income, or use earnings to cover unexpected expenses.