Understanding Financial Liquidity: Definition, Asset Classes, Pros & Cons

What Is Financial Liquidity?

Financial liquidity is a measurement of how quickly an asset can be converted to cash. It is important to individuals, businesses, and markets because it impacts all of them.

In addition to measuring how easily assets can convert to cash, financial liquidity is also crucial for managing finances.

Understanding liquidity ratios, like the current ratio and quick ratio, is important for gauging financial health.

Liquidity solutions can range from selling assets to borrowing against them for quick cash access.

Liquidity in markets ensures ease of trading securities and price efficiency.

This article explains why it’s crucial to understand what financial liquidity is, how to measure it, and why it is important.

Deep Dive Into Financial Liquidity

Assets like stocks and bonds are very liquid since they can be converted to cash within days. However, large assets such as property, plant, and equipment are not as easily converted to cash. For example, your checking account is liquid, but if you owned land and needed to sell it, it may take weeks or months to liquidate it, making it less liquid.

Before investing in any asset, it’s important to keep in mind the asset’s liquidity levels since it could be difficult or take time to convert back into cash. Of course, other than selling an asset, cash can be obtained by borrowing against an asset. For example, banks lend money to companies, taking the companies’ assets as collateral to protect the bank from default. The company receives cash but must pay back the original loan amount plus interest to the bank.  

Liquidity Across Different Asset Classes

Cash is the most liquid asset, and companies may also hold very short-term investments that are considered cash equivalents and are also extremely liquid. Companies often have other short-term receivables that may convert to cash quickly. Unsold inventory on hand is often converted to money during the normal course of operations. Companies may also have obligations due from customers to whom they’ve issued a credit.

Some investments are easily converted to cash, like public stocks and bonds. Since stocks and bonds have public exchanges with continual pricing, they’re often referred to as liquid assets.

Other investment assets that take longer to convert to cash might include preferred or restricted shares, which usually have covenants dictating how and when they can be sold. In addition, specific types of investments may not have robust markets or a large group of interested investors to acquire the investment. Consider private shares of stock that cannot easily be exchanged by logging into your online brokerage account.

Coins, stamps, art, and other collectibles are less liquid than cash if the investor wants full value for the items. For example, if an investor wants to sell to another collector, they might get full value if they wait for the right buyer. However, because of the specialized market for collectibles, it might take time to match the right buyer to the right seller.

Land, real estate, or buildings are considered among the least liquid assets because they could take weeks or months to sell. Fixed assets often entail a lengthy sale process inclusive of legal documents and reporting requirements. Compared to public stock that can often be sold in an instant, these types of assets simply take longer and are illiquid.

Navigating Market Liquidity

Market liquidity refers to a market’s ability to allow assets to be bought and sold easily and quickly, such as a country’s financial markets or real estate market. 

The market for a stock is liquid if its shares can be quickly bought and sold and the trade has little impact on the stock’s price. Company stocks traded on the major exchanges are typically considered liquid.

If an exchange has a high volume of trade, the price a buyer offers per share (the bid price) and the price the seller is willing to accept (the ask price) should be close to each other. In other words, the buyer wouldn’t have to pay more to buy the stock and would be able to liquidate it easily. When the spread between the bid and ask prices widens, the market becomes more illiquid. For illiquid stocks, the spread can be much wider, amounting to a few percentage points of the trading price. 

The time of day is important, too. If you’re trading stocks or investments after hours, there may be fewer market participants. Also, if you’re trading an overseas instrument like currencies, liquidity might be less for the euro during, for example, Asian trading hours. As a result, the bid-offer spread might be much wider than if you had traded the euro during European trading hours.

Key Metrics for Measuring Financial Liquidity

Liquidity for companies typically refers to a company’s ability to use its current assets to meet its current or short-term liabilities. A company is also measured by the amount of cash it generates above and beyond its liabilities. The cash left over that a company has to expand its business and pay shareholders via dividends is referred to as cash flow.

Below are three common ratios used to measure a company’s liquidity or how well a company can liquidate its assets to meet its current obligations.

Liquidity Ratios

The current ratio (also known as working capital ratio) measures the liquidity of a company and is calculated by dividing its current assets by its current liabilities. The term “current” refers to short-term assets or liabilities that are consumed (assets) and paid off (liabilities) is less than one year. The current ratio is used to provide a company’s ability to pay back its liabilities (debt and accounts payable) with its assets (cash, marketable securities, inventory, and accounts receivable). Of course, industry standards vary, but a company should ideally have a ratio greater than 1, meaning it has more current assets than current liabilities. However, it’s important to compare ratios to similar companies within the same industry for an accurate comparison.

The quick ratio, sometimes called the acid-test ratio, is identical to the current ratio, except the ratio excludes inventory. Inventory is removed because it is the most difficult to convert to cash when compared to the other current assets like cash, short-term investments, and accounts receivable. In other words, inventory is not as liquid as the other current assets. A ratio value of greater than one is typically considered good from a liquidity standpoint, but this is industry-dependent. 

The operating cash flow ratio measures how well current liabilities are covered by the cash flow generated from a company’s operations. The operating cash flow ratio is a measure of short-term liquidity by calculating the number of times a company can pay down its current debts with cash generated in the same period. The ratio is calculated by dividing the operating cash flow by the current liabilities. A higher number is better since it means a company can cover its current liabilities more times. An increasing operating cash flow ratio is a sign of financial health, while those companies with declining ratios may have liquidity issues in the short term.

The Importance of Liquidity

In general, it’s advantageous to hold assets that are liquid. These types of assets or investments may be associated with lower fees, penalties, or transaction costs to convert to cash. Other parties are more likely to trade for the goods, and there is usually strong accounting guidance for items easiest to value and sell.

There is also a psychological advantage to liquid assets. Some individuals or companies take peace of mind knowing they have resources on hand to meet short-term needs. Instead of having to force-sell assets in a short time frame, liquidity is important as it helps foster a strategic, thoughtful, proactive environment vs. a reactionary environment.

Financial liquidity also plays a vital part in the short-term financial health of a company or individual. Each has bills to pay on a recurring basis; without sufficient cash on hand, it doesn’t matter how much revenue a company makes or how expensively an individual’s house is valued at. Consider a company with $1 billion of fixed assets but only $1 of cash. This company would be unable to pay its $10,000 rent expense without having to part ways with some fixed assets.

Disadvantages of Liquidity

For some investors and in some circumstances, illiquid assets actually hold an advantage over liquid assets. Consider certificates of deposit. CDs often have a higher rate of return than a bank account. If a company or individual can sacrifice liquidity, it may generate higher returns from the asset.

As illiquid assets are more difficult to sell, they also have the advantage of potentially being less volatile. Imagine two assets: one is a single share of public stock for Amazon, and the other is a single acre of farmland in Riverdale, North Dakota. As investors cannot panic sell the farmland but can emotionally trade the single share of public stock, illiquidity may protect investors from themselves and force them to hold assets through market turbulence.

Real-World Example of Financial Liquidity

In fiscal year 2021, Disney (DIS) reported total revenue of $67.4 billion. The company also emerged from the COVID-19 pandemic and reported a net income of $2.5 billion, turning the company around from a loss in 2020. It could be argued that Disney’s financial performance in 2021 was better than in 2020.

However, digging into Disney’s financial liquidity might paint a slightly different picture. At the end of fiscal year 2021, Disney reported having less than $16 billion of cash on hand, almost $2 billion less than the year before. In addition, the company’s total current assets decreased by roughly $1.5 billion, even though the company’s total assets increased by over $2 billion.

Looking at Disney’s liabilities, the company ended fiscal year 2021 with just over $31 billion of total current liabilities. This is an increase of over $4 billion from the year prior. Each of the company’s accounts payable, current portion of borrowings, and deferred revenue balances increased from the year prior. Analyzing Disney’s current ratio shows the company’s liquidity worsened:

Current Ratio (2021): ($33.657 / $31.077) = 1.08

Current Ratio (2020): ($35.251 / $26.628) = 1.33

Therefore, although Disney outperformed the year prior and generated more sales in 2021 than 2020, the company’s liquidity worsened. At the end of 2021, the company had less short-term resources to meet short-term obligations.

The Bottom Line

Liquidity helps maintain financial flexibility and stability. Companies with a lack of liquidity could be forced to sell assets they don’t want to liquidate in order to meet short-term obligations, such as loans to banks and creditors. 

Market liquidity is critical if investors want to get in and out of investments. You have to monitor the liquidity of an investment or potential investment before entering a position.