What is Liquidity?
Liquidity relates to quick access to cash. Individuals hold assets or security, and liquidity refers to the ease with which these may be bought or sold in the market for conversion into cash.
Cash is held to be the standard for liquidity as it can be converted to other assets most easily. It can be measured by two methods – market liquidity and accounting liquidity.
Types of Liquid Assets
Liquid assets are such assets held by businesses or individuals, which can be converted into cash quickly. It can include cash, marketable securities as well as money market instruments. All such assets are reflected in the balance sheet of the company.
Cash and savings accounts usually retain the highest form of liquidity that may be owned either by businesses or individuals. The following assets can also be liquidated easily –
The total amount of money, which is accessible, is a form of liquid asset. Cash can be utilised to resolve any existing liabilities. Cash in an account will also be considered as liquid since it can be withdrawn for settling obligations at any time.
- Cash equivalents
Cash equivalents are usually highly liquid investments which have maturity ranging up to only 3 months. It has substantial credit quality and may be immediately used owing to lack of any restriction. Examples of cash equivalent include commercial papers and treasury bills, amongst others.
- Accrued income
The income that one has already earned, but the amount is yet to be deposited in the associated account is accrued income. In such a case, the delayed income is expected to arrive any day, making it a liquid source of funding.
A stock market is categorised to be liquid due to the existence of a high number of buyers and sellers. One can sell off their owned stocks quickly through electronic markets. Thus, according to the demand, an individual or business can convert equity securities into cash quickly.
Therefore, owning a considerable pool of equity shares is a sign of liquidity in stocks for a particular individual or company.
- Government bonds
Governments may raise funds through bonds wherein investors extend a loan to the government by way of a debt instrument in lieu of an interest rate. Investors stand to gain assured returns at periodic intervals.
Government bonds are primarily held to be fixed-income assets. An investor receives the original investment on the maturity date. However, maturity tenures differ from one bond to another. Similar to stocks, government bonds may be held as an investment or traded in the open market.
For example, a government bond of 5 years’ period may have reached only half of its term when the investor notices a more attractive investment opportunity elsewhere. In such situations, the investor has the option to sell the government bond to another investor recovering the original quantum.
- Promissory notes
Promissory notes are primarily signed documents indicating a written promise to pay the specified sum of money to the recipient on a particular date. This financial instrument is a promise to repay a debt to the payee.
Such promissory notes act as an alternative source of funding for individuals who do not want to deal with a bank. The financing party may be a corporation as well as an individual, which on mutually agreed terms, carries the note and initiates financing.
- Accounts receivable
Accounts receivable refer to invoices and bills that a company has already generated for its consumers, but has yet to receive the payments settling such bills. The unpaid balance amounts to being assets for the particular company.
Liquidity example, in this case, involves unpaid invoices of an electric company amounts to accounts receivable for the electricity provided to its customers. The account receivables are liquidated on payment of electricity bills.
- Marketable securities
Publicly listed companies may issue short-term financial instruments linked with debt or equity securities for the purpose of raising funds, which are known as marketable securities. These instruments are primarily used to finance business expansions or other activities. The debt securities are also issued by the government for carrying out public projects or funding public expenditures. Such debt securities may include Treasury Bills.
Marketable securities usually have short maturity periods like 11 months which makes the liquidation of these investments easy as opposed to securities that have long-term maturity periods. Most common examples of such financial instruments are bonds, stocks, exchange-traded funds and preferred shares amongst others.
- Certificate of deposits
Certificate of deposit entitles the holder of such investment product to a lump sum amount, including the principal and the interest accrued on the principal. The certificate of deposit will lead to liquidity in reaching the maturity period. It amounts to a special kind of savings instrument, which freezes the interest rate, term period, principal, and the bank or the credit institution after it is opened.
Liquidation of a certificate of deposits before the maturity period will attract penalty, and the penalty amount usually depends on the term period.
Different Methods for Measuring Liquidity
Market liquidity indicates such condition of the market when assets may be purchased or sold off quickly. Such liquidity is particularly evident in the case of real estate or financial market. The conversion of assets into cash across markets is also referred to as liquidity in economics.
The market for equities or stocks can be held to be liquid only if the purchase and selling of shares can happen quickly with minimal impact on the price of the shares. The shares that are traded on big stock exchanges are usually found to be liquid.
The ease with which a company or an individual is capable of meeting financial obligations, using liquid assets constitutes accounting liquidity. It involves the comparison of the liquid assets held by the company or an individual to that of current liabilities in a financial year. Accounting liquidity may be measured by current ratio and cash ratio.
Current ratio is also referred to as working capital that takes into account the current assets that may be liquidated into cash within a financial year.
|Current Ratio = Current Assets / Current Liabilities|
On the contrary, cash ratio measures the cash flow that will meet the current liabilities. It is usually an indicator of short-term liquidity.
|Cash Ratio = Cash (or equivalents) + Investments (short-term) / Current liabilities|
Liquidity is important for individuals, corporations, as well as markets. In spite of holding high-value assets, any of these entities may experience liquidity crunch if such assets cannot be converted into cash within a short period. It may so happen that there may be distress selling of assets in order to meet the liquidity demands or short-term obligations.