What is liquidity in finance, investing and accounting?
Let’s look at liquidity for a company, liquidity in markets, and liquidity for investors.
The term liquidity is used very often in financial news.
There might be worries about the liquidity of ABC Corp.
Will it be able to pay its bills and survive?
Central banks might be providing more liquidity to financial institutions in times of economic
turbulence, so they in turn can provide loans to consumers and businesses.
Consumers might decide to hold more liquidity,
if they are seeking a safety-net for unplanned expenses.
What is the definition of liquidity?
Liquidity is the availability of liquid assets to a company, market or trader/investor.
What is the first thing you think of when you hear the word “liquid”?
Water! Here’s a glass of tap water in my kitchen.
Here’s another glass of water, solidly frozen.
If you turn it upside down, nothing happens.
Ice is not liquid, water is.
So is liquid versus frozen binary?
Water is either liquid or frozen?
Not quite, there is an intermediate state: water might be in the process of freezing,
and ice might be in the process of defrosting.
The third glass in the middle is 20% liquid, 80% frozen.
When I pour out the water, a big chunk of ice remains.
When you think about liquidity in finance, investing and accounting, think about an infinite
number of intermediate stages: 10/90, 20/80, 30/70, 40/60, etcetera.
Assets can be fully liquid like water, fully frozen like ice, or anywhere in between.
Let’s go one level deeper into liquidity for companies.
If you review a company’s financial statements,
liquidity means the ability to pay short-term obligations.
An example is a CFO stating that his company has ample liquidity of 3 billion dollars:
2 billion in cash and 1 billion in a revolving loan (also called revolving credit facility,
a loan where the funds are drawn and repaid as needed by the borrower).
If you want to review the liquidity of a company from its financial statements, the current
ratio is a very useful financial ratio.
Let’s look at liquidity on the balance sheet.
For reporting in the US, the assets of a company are listed from most liquid at the top to
least liquid at the bottom.
Cash is very liquid, in most cases you can use it immediately to pay your obligations.
Accounts Receivable are very close to cash.
Once the customer pays you, you can use that cash to pay your own bills.
Inventory is still reasonably liquid, but you will have to sell it first, and then collect
the receivable, for inventory to turn into cash.
Fixed assets are not very liquid.
To convert them to cash, you will need to produce product on it, sell the product, and
collect the receivable.
Goodwill is an example of an intangible asset that is very illiquid.
So if you judge the balance sheet of this company purely on the assets side of the balance
sheet, you could say that it is not very liquid, as most of the asset value is in fixed assets
and goodwill.
If you compare current assets to current liabilities, things look a little bit better.
The company has a current ratio of 2: for every dollar of current liabilities there
are two dollars of current assets.
A strong level of liquidity.
Market liquidity.
When I look at the most active stocks on the NASDAQ on the day I made this video, well-known
names like Amazon, Apple and Alphabet Inc show up.
These are heavily traded stocks,
with billions of dollars of transaction volume on normal days.
So that’s a first version of defining market liquidity: having lots of buyers and sellers
available, forming an active market.
A second version of market liquidity is the ability to buy or sell something without causing
a large price change.
If I need to liquidate my portfolio today, will I able to do so at stable prices, or
will my selling cause a price drop which would decrease the amount of cash I get in return
for selling my stocks.
Individual liquidity for a trader or investor.
Let’s look at the investment portfolios of Jim and Jane.
Jim has invested directly in private companies, real estate, and vintage cars.
Jane has invested in blue chip stocks, bonds, and holds cash.
You could say that Jim’s portfolio is largely frozen or illiquid, and Jane’s portfolio
is relatively liquid.
We are not looking at their returns here (either Jim or Jane could outperform), we are only
judging how flexible the investment portfolios are in exchanging assets for other assets.
If Jim and Jane both love art and go to an auction, who is in the best position to bid?
Most likely that would be Jane, she can pay in cash or quickly sell stocks or bonds on
the day of the auction, whereas it would take Jim a lot longer to turn his assets into cash.
Or if Jim does want to sell his existing investments fast, he might need to sell at a significantly
lower price.
Liquidity is the availability of liquid assets to a company, market or trader/investor.
Assets can be fully liquid like water, fully frozen like ice, or anywhere in between.
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