Liquidity describes how quickly an asset such as a car, a house, or a business can be easily bought or sold. For example, assets and bonds are very liquid and can be easily bought or sold. However, substantial assets such as properties are not easily converted to cash and may take weeks or months to sell.
Cash is considered the standard for liquidity since it can easily convert to other assets. For example, if you want a $900 phone within an immediate period, cash is the most efficient asset to purchase it. If you have an antique typewriter that has been appraised for $900, you are more unlikely to find someone willing to trade the phone for the device to meet your period of acquiring the item. The easiest way to obtain it is to sell the antique typewriter and use the cash to purchase the phone.
Liquidity in the market is the market’s ability to allow assets to be sold and bought quickly and easily, such as the real estate market or financial market.
For example, the market for a stock is liquid if its shares can exchange quickly, and the trade has a little impact or didn’t cause a change in the stock’s price. The bid price (the amount the buyer offers per share) and the asking price (the price the seller is willing to accept) should be close to each other to make it easier to liquidate. If the spread between the prices widens, the market becomes more illiquid or difficult to convert.
Accounting Liquidity is the measure of the ability to pay off liabilities as they come due. It means comparing your liquid assets to your current debts or financial obligations that come due. In the example above, your antique typewriter as an asset is relatively illiquid and may not be its full value of $900 when in a pinch or when you need to attend to your financial obligations. With this, you need to measure your accounting liquidity to meet your abilities in paying off debts.
Ratios for measuring accounting liquidity
There are different types of rates that are vital in measuring accounting liquidity. It differs in how strictly they define liquid assets:
- Current Ratio – this is the simplest and least strict ratio. It measures the liquidity of a company by calculating the difference between current assets and current liabilities. It measures the company or an individual’s ability to pay its obligations or debts and account payables with its assets such as cash, securities, inventory, and account receivables (money balance that has not been yet paid).
- Quick Ratio – or sometimes called the acid-test ratio. It is identical to the current ratio, with the exclusion of inventory, or the complete list of items such as goods in stock and properties. The ratio removes inventory because it is the most difficult to convert into cash than other assets like cash, account receivables, and short-term investments. Inventory is not as liquid as the other current assets.
- Operating Cash Flow Ratio – this measures how well current liabilities are covered by the cash flow generated from the company’s operations. It is a measure of short-term liquidity that calculates the number of times a company can pay down its current liabilities with cash generated in the same period.
Liquidity is important not only to companies or businesses but even for individuals. You could run into liquidity or financial issues if the assets cannot readily be converted into cash, however high they may be. Unable to readily meet financial obligations for a short-term can result in selling your assets. You don’t want to liquidate to meet them. Be sure to monitor the liquidity of a stock or current assets to see your abilities in cash.