What is liquidity?
Introduction to liquidity
‘Liquidity’ – In simple terms of business, economics or investment, market liquidity is an asset’s ability which is to be sold without causing a significant movement in the price. It has the ability which causes minimum loss of value. It can also be stated as the business’s ability to catch payment obligations, in terms of processing sufficient liquid assets. So, we have three different instances to understand liquidity:
General definition – The ease with which an asset can be converted to cash (It defines the liquidity of that asset).
Accounting – The ability of current assets of a business, to meet the current liabilities without causing much loss of value.
Investment – How quickly an investment portfolio can be converted to cash or liquid asset.
Assets which can be easily sold or bought are called liquid assets.
Money or cash is the most liquid asset and can be used for economic accomplishments like buying, selling or paying debt, meeting immediate wants and needs. The economic currencies may suffer, due to the loss of market liquidity in many liquidation events.
Definitions of Liquidity
- Liquidity can be defined as the degree to which an asset or security be bought or sold in the market without causing any change in the asset’s price. Consequently, assets which are easily sold or bought in market termed as liquid assets and it can be characterized as a high level of trading activity.
- Marketability- The ability to convert an asset to cash instantly is known as marketability.
Liquidity is the amount of capital which is available for spending and investment. As most of the capital is credit rather than cash, that’s why large financial institutions prefer investment using borrowed money.
High Liquidity – High liquidity means there is a lot of capital which usually happens when interest rates are low, and therefore capital is easily available in the market. Accordingly, low interest rate means credit is cheap that reduces the venture of borrowing. That is the reason; the return only has to be higher than the interest rate. In that manner, high liquidity stimulates economic growth.
To set the target for Fed fund rate, the Federal Reserve manages liquidity by guiding the interest rate with monetary policy.
To calculate Liquidity, there is no specific formula but we can evaluate liquidity by using liquidity ratios.
Current Ratio– The company current assets separated according to the current liabilities and this ratio determines whether a company could pay off all its short-term debt with the money it got from selling its assets.
Quick Ratio– This ratio is same as the current ratio, only using just cash, accounts receivable and stocks/bonds. Correspondingly, the business can’t count its inventory or prepaid expenses that can’ be easily sold.
Cash Ratio– As the name implies cash, the company can only use it cash to pay off its debt. If the cash ratio is one or more greater, that means the business will have no problem in paying its debt, and has plenty of liquidity.