What Is Liquidity and How Do You Calculate It?

The importance of liquidity can’t be overstated. Liquidity helps investors quickly access the wealth they create on various financial markets, whether on the New York Stock Exchange (NYSE) or the crypto market. 

Liquidity is also the fuel that keeps financial markets moving quickly without any rapid price fluctuations. It’s critical during market volatility, or for businesses needing to quickly adapt to changing economic conditions. However, liquidity isn’t just essential for investors. Maintaining high liquidity is also pivotal for business owners who need financial flexibility during uncertain times. 

If you’re ready to learn more about liquidity and its impact on world financial markets, this guide will provide all the information you need to get started. 

What Is Liquidity?

Liquidity is simply the ease at which an asset can be converted into cash without affecting its market price. You can easily convert liquid assets into cash, while illiquid assets can face certain market difficulties that can affect their final price. 

The most common liquid assets are:

• Cash: This is the most liquid asset, and it’s the basis for determining the liquidity of all assets. 
• Money market funds: These managed funds only invest in cash, cash equivalents, and short-term debt securities that are easy to sell on the market. 
• Stocks and bonds: Stocks are easy to sell on a stock exchange, and treasury bonds are considered cash equivalents since they are actively sought-after and traded. 
• Exchange Traded Funds (ETFs): ETFs are essentially a bundle of different actively traded assets an investor can purchase to diversify their portfolio and minimize their risk. 
• Bank and savings accounts: Bank accounts and savings accounts hold physical cash that owners can withdraw at any time. 
• Mutual funds: A mutual fund is a collective investment account shared by multiple investors who can sell their assets for profit at any time. 
• Certificate of Deposits (CDs): With a CD, you agree to place your money into a secured account operated by a bank or credit union for a specific period of time in exchange for a higher interest rate.
• Precious metals: Gold and silver are two precious metals that are always in demand, so you can collect and sell them without price slippage. 
• Accounts receivable: This is the amount of money a business will receive from clients or customers. It’s often guaranteed and backed by a contractual agreement, which means businesses can use it as a tradable asset or collateral. 

 

Some examples of illiquid or less liquid assets include:

• Real estate: The real estate market is a prime example of a constantly fluctuating market. It may take several months or years for even the wealthiest people to liquidate their real estate portfolios. 
• Cars: Vehicles rapidly deteriorate in value immediately after purchase. So it’s highly unlikely that you’ll be able to sell your car for what you paid for it.
• Art and collectibles: Antiques and artwork aren’t easy to sell at auctions, mainly because they are a niche investment category and their value is difficult to determine. 
• Private company interests: Stocks or securities in a private company or startup aren’t liquid because they’re not backed by much market security. It’s impossible to know how much these stocks are actually worth or if they can be recouped later. 
• Private loans: Loans made to small businesses and individuals may not be repaid within a reasonable time or at all. 

 

In short, liquid assets are easy to convert into cash—illiquid assets are the opposite. 

Why Is Liquidity Important?

Liquidity is the lifeblood of any business or financial market. Here is why liquidity is essential for businesspeople and investors:

• Investors: In a financial market, high liquidity means active supply and demand for an asset. This makes it easy for buyers to find sellers and vice versa.
• Businesspeople: Companies with liquid assets can pay their bills and meet all their obligations on time. They have the cash on hand to pay their debts without raising additional capital. 

As we’ve already discussed, not all assets are liquid. Investors with illiquid assets often have to accept a lower selling price if they need to immediately liquidate an asset. 

For example, let’s say an investor purchased a $8.5 million Miami mansion in 2005. Nearly two decades later, they decided to sell for an asking price of $15 million. Unfortunately, the mansion stayed put for more than a year because of a slow real estate market due to a recession. 

The investor must either endure the market until the property sells or lower the asking price. In either case, this proves that the property is an illiquid asset. This scenario is happening for Michael Jordan, whose Chicago mansion has been on the market since 2012. 

Liquidity means financial markets can move quickly and attract more buyers and sellers. It also means businesses can cover their bills and debts without taking out expensive loans or raising more capital. 

Understanding How Liquidity Works

You can determine liquidity based on these three main factors:

1. Market conditions: The state of the market will always determine an asset’s liquidity. For example, a sudden recession could slow the real estate market for prospective sellers. 
2. Trading volume: This refers to the number of shares or securities exchanged between buyers and sellers. The higher the volume, the more popular an asset is. 
3. Asset characteristics: Some assets are more attractive than others. Gold and silver are some of the most widely sought-after assets in the world. However, an antique may not mean much to many investors. 

 

Stock and crypto exchanges constantly monitor market liquidity, as maximizing liquidity in their markets encourages rapid transactions. Partners like AlphaPoint provide crypto liquidity solutions, helping businesses and investors profit from healthy buyer and seller interactions. 

Different Forms of Liquidity

Liquidity is a broad financial term that’s familiar in both business and investing. Here is how liquidity differs in each area.

Market Liquidity 

Market liquidity directly impacts asset trading, pricing, and overall financial markets. It’s measured by the ease at which an asset can be traded, sold, and converted into cash. 

Market liquidity is maintained by both market makers and liquidity partners (LPs). Market makers buys and sells securities for its own accounts, ensuring that transactions on an exchange are moving at a fast pace.

Generally speaking, they deliver liquidity to a financial market. 

In addition, LPs are very similar. They quote buy and sell bids on a tradable asset to profit from the bid–ask spread. In exchange, they supply liquidity to a market by acting as the middle-man between markets and financial institutions. 

With the help of market makers and LPs, markets are always supplied with orders and avoid stagnation. 

Accounting Liquidity 

Accounting liquidity determines a company’s financial health and ability to pay off its debts with available cash. There are several different methods you can use to calculate accounting liquidity, including the current ratio method (more on this later).

Businesses and investors alike have a vested interest in maximizing their liquidity to ensure steady cash flow under any market condition. 

How To Calculate Liquidity

Sometimes, it’s not enough to know the difference between liquid and illiquid assets. Learning how to calculate a specific asset’s liquidity using the methods below can help you make sound financial decisions. 

The Current Ratio Method

The current ratio method is a simple way of calculating a company’s accounting liquidity. To determine liquidity, you can divide the company’s current assets by its current debts or liabilities. 

Current assets, like accounts receivable, are those that the company can liquidate within one year. Current liabilities are debts that the company expects to pay within one year, like a short-term loan. 

A good current ratio depends on the company’s historical performance and industry. However, a current ratio of 1.50 or more signifies high liquidity. 

For example, this indicates that the company had $1.50 of current assets for every $1 of liabilities. 

The Quick Ratio Approach

The quick ratio determines the extent to which a business can pay off its short-term debts with its most liquid assets, such as:

• Cash and cash equivalents
• Marketable securities
• Accounts receivable

 

To calculate a company’s liquidity using this method, you must total up all current liabilities as indicated on the most recent balance sheet. This means that a quick ratio of 1 indicates you have $1 in liabilities for every $1 in assets.

The Acid-Test Ratio

The acid-test ratio determines whether a company has enough assets to cover its short-term obligations. A ratio of 1.0 or more indicates a company can easily pay its short-term debts using its highly liquid assets. 

For instance, an acid-test ratio of 2 shows that a company has twice the amount of liquid assets compared to liabilities. 

A ratio under 1.0 indicates a company might struggle to pay its bills on time. The acid-test ratio doesn’t consider assets that are difficult to liquidate, such as inventory. The formula also doesn’t count assets that are not already in hand, like accounts receivable.

The Cash Ratio Calculation

Unlike the other liquidity ratios, the cash ratio calculation refers to a company’s ability to pay off its short-term obligations only using cash and cash equivalents. 

This calculation is a pure indicator of a company’s liquid assets. Creditors often use the cash ratio when deciding how much to lend a company. 

An ideal cash ratio is between 0.5 and 1. For example, a company with $200,000 in cash and $150,000 in liabilities has a 1.33 cash ratio. 

Real-World Examples of Liquidity

Here are a couple of helpful examples that can provide a greater understanding of liquidity. 

If a company is experiencing a financial crisis, it can liquidate its assets to pay off short-term debts, such as rent, salaries, and overhead expenses. 

For example, it can convert assets like accounts receivable into cash within a reasonable time to avoid taking out additional loans or going bankrupt. Having liquid assets means this company has financial security during uncertain times and the flexibility to maneuver successfully without much incoming revenue. 

Investors can also benefit from liquidity. For example, an individual investor can sell off some of their stocks to fund a large, unexpected expense, instead of maxing out a credit card or taking out a loan.

Common Questions About Liquidity

If you need more information about liquidity and its importance in financial analysis, you can refer to the frequently asked questions (FAQs) below.

What Counts as a Highly Liquid Asset?

The most liquid assets are:

• Cash: Cash is the most liquid asset available. 
• Stocks: Stocks are easy to sell or trade on an exchange. The seller can receive the cash within a few business days. 
• Short-term government bonds: These debt securities usually have a short maturation period. They are one of the most secure assets available, mainly because they are government-backed and pay fixed-rate interest.

 

What Are Some Examples of Illiquid Assets?

Illiquid assets can take a while to liquidate and are significantly affected by market conditions. Some common examples are:

• Real estate: Buying and selling real estate can take much longer than liquid assets, like stocks and bonds. 
• Collectibles: Appraising collectibles and antiques can take a very long time, and these assets only appeal to a small group of buyers, making them difficult to sell. 
• Private equity: Stocks and company interests in new businesses aren’t guaranteed. Investors who want to liquidate their stocks could face trouble if the company experiences financial issues or bankruptcy. 

 

Why Are Some Stocks More Liquid?

The most straightforward answer is that the most liquid stocks receive the most attention from investors. Of course, other factors can affect a stock’s liquidity, such as:

• Market capitalization: The most profitable companies usually control a large share of their respective markets. Buying these stocks is a safer option than their less-successful competitors. 
• Trading volume: A stock with high trading volume backed by robust market activity is easy to sell.
• Market conditions: Economic growth, inflation, federal interest rates, and recession can all affect stock liquidity. For example, economic growth in the oil sector could increase the trading volume of oil-related stocks. 

 

How AlphaPoint Global Assists With Liquidity

Overall, liquidity helps drive traditional and digital financial markets by promoting market stability. Liquidity gives investors and businesspeople confidence that they can quickly convert their assets into cash without price slippage. 

But investors and entrepreneurs aren’t the only parties interested in maximizing liquidity. Crypto exchanges and financial institutions also need liquidity to increase market participation, which is where liquidity partners (LPs) like AlphaPoint Global come in. 

AlphaPoint Global provides liquidity solutions that help make digital assets more convenient and accessible for everyone. By partnering with AlphaPoint Global, crypto businesses can utilize a variety of innovative tools to add deep liquidity to their order books. 

Ready to see how AlphaPoint delivers enhanced liquidity for digital asset markets? Request a demo today.