What exactly is liquidity?

Most investors will have heard of the term ‘ liquidity ‘. This is an economic term with a lot of theory behind it. Basically, it indicates how easily an asset (product) can be sold, without the price of this product being negatively affected . It is therefore about the conversion of a product into money. 

When talking about liquidity, one tries to indicate how easily a product can be converted into money, without the price being negatively affected. With high liquidity, the sale of a product is easier to realize than with low liquidity. Within the investment world, there can be considerable differences when it comes to the level of this.

The different types

Liquidity has different forms. Below you will find information about different forms.

• Liquidity of assets: when it comes to the liquidity of assets, it should be said that different assets differ in liquidity. When a product has a relatively high liquidity, it can be sold relatively easily. This also applies the other way around. A product with low liquidity will be more difficult to convert into money. Examples of such products with low liquidity are a rare vase or a business building. Products with high liquidity are, for example, shares . Subsequently, there is also a difference in liquidity within these shares themselves. This liquidity is largely determined by the market capitalization.
• Market liquidity: where the above specifically concerned assets, it becomes clear here that liquidity also occurs in other aspects. Market liquidity is a concept that plays a greater role in the investment world and it often concerns the liquidity of the stock market . If you would like to quickly gain insight into the liquidity of a share, you can take a look at the spread. A low spread indicates that the share in question has a relatively high liquidity.
• Accounting liquidity: accounting liquidity is a relevant factor for economists and investors. It also provides a handle when it comes to measuring the financial health of a company. The accounting liquidity of a company is measured on the basis of the short-term obligations within a year. This includes, for example, dividends to be paid , a tax debt or creditors.

Calculate liquidity

Now that it is clear what the concept itself entails, the question is what exactly you can do with it. You can use it when you are considering purchasing a specific share or other product. Does the company in question have low liquidity? Then it is possible that there is not enough money available for the short term. This can cause the company to build up debts and will generally make it more difficult to grow. However, high liquidity is not always ideal. A company with high liquidity may have access to a lot of funds, but it may be that these are not invested well.

Calculate ratios

Below you will find a number of short calculation models that will help you calculate the liquidity of a company. It is always a ‘ratio’, so a proportion. If the proportion is 1, it is fairly average. In general, a value above 1 is seen as a healthy value.

• Current ratio: this ratio looks at current assets versus current liabilities. It therefore says something about how well a company can repay debts in the short term using short-term assets. The calculation is quite simple and goes as follows: current ratio = current assets / current liabilities .
• Quick ratio: in English this ratio is also called the ‘acid test ratio’. This is actually based on the aforementioned current ratio. This time, however, the inventories are not included. Keep in mind that this remains a snapshot. If a company takes on a debt shortly after the calculation, this can change the ratio. The formula is as follows: quick ratio = (cash + equivalents + creditors) / current liabilities .
• Cash ratio: The cash ratio tells us something about the ability of a company to pay off short-term obligations with only cash (and/or cash equivalents). The formula is as follows: cash ratio = (cash + cash equivalents) / current obligations .

Liquidity risk

Liquidity risk is closely related to the general principle of liquidity. In short, liquidity risk is a kind of inference on liquidity. Roughly speaking, assets with high liquidity carry lower liquidity risk. This is because assets with higher liquidity can be converted into money more easily and quickly. That rare vase that was discussed earlier has a fairly high liquidity risk. That is to say, it most likely has a fairly low liquidity.

If you are active on the stock exchange and are considering investing in certain shares, it is relevant to look at the liquidity in conjunction with the liquidity risk. This will give you a good picture of the company’s ability to pay off debts and thus provide insight into the financial health of this company.