What is liquidity?
Liquidity refers to the ease with which a company or individual can buy or sell an asset without causing significant price movements. It measures how quickly we can convert an asset into cash without affecting its market value. In other words, liquidity represents the ability to convert an asset into cash or to trade it for another asset swiftly and at a reasonable price.
Liquidity can also refer to a company’s ability to meet its short-term financial obligations and convert its assets into cash without causing significant disruptions to its operations. It measures the company’s ability to generate sufficient cash flow to cover its immediate liabilities.
A company with strong liquidity is better positioned to handle unexpected expenses, repay debts, and seize growth opportunities. Conversely, a company with poor liquidity may face difficulties meeting its financial obligations and may be at a higher risk of insolvency.
What do we mean by ‘liquid asset’?
The liquidity of an asset refers to how readily we can convert it to cash at a price consistent with its value. We can quickly sell highly liquid assets. Examples include cash, government bonds, and actively traded stocks.
These assets typically have many buyers and sellers, resulting in a tight bid-ask spread (the difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to accept). A consistent supply of willing buyers and sellers indicates that an asset can be considered liquid.
High liquidity reduces the cost of trading and allows stakeholders to enter or exit positions more easily. We typically consider ASX shares highly liquid because they can be bought and sold quickly. In contrast, real estate is regarded as a relatively illiquid asset because of the cost and time it takes to sell on the market.
All ASX shares are technically liquid, but some are more liquid than others. An ASX blue-chip share like Commonwealth Bank of Australia (ASX: CBA) has a large market capitalisation, a relatively large supply of shares outstanding, and usually attracts a large volume of share transactions during a typical trading day. Because of all these factors, we can consider CBA shares highly liquid.
In contrast, an ASX company with a small market capitalisation, such as shares outside the S&P/ASX 200 Index (ASX: XJO) or the All Ordinaries Index (ASX: XAO), will usually offer far less liquidity.
That’s because fewer shareholders are trading a smaller volume of shares on an average trading day. As such, shareholders might not find it easy to buy or sell these shares at a consistent market price. They may also find that a large buy or sell order can significantly move the share price.
Because of these factors, we consider small-cap ASX shares to be less liquid than large-cap ASX shares. When trading illiquid assets, finding a buyer or seller may be more challenging, and executing a transaction can take longer or require a larger discount or premium to attract counterparties.
Liquidity in the market
Market liquidity is crucial in financial markets because it enhances efficiency and reduces the risk of price manipulation. It provides the ability to quickly convert holdings into cash or switch between different assets, which increases the market depth and facilitates price discovery.
In addition, market liquidity is important for banks and other financial institutions as they rely on readily accessing cash or liquid assets to meet their obligations.
Company liquidity
Company liquidity refers to the ability of a company to meet its short-term financial obligations by having sufficient cash or easily convertible assets available. It is a measure of the company’s ability to generate cash flow and have access to liquid resources when needed.
Companies need liquidity to meet short-term financial obligations, such as paying suppliers, employees, and creditors. Adequate liquidity ensures that a company can cover its day-to-day expenses and maintain smooth operations. Companies that have borrowed funds need liquidity to service their debt obligations, including interest payments and principal repayments. Insufficient liquidity can lead to difficulties meeting these obligations, resulting in credit downgrades, higher borrowing costs, or even default.
Liquidity is a key measure of financial stability. Companies with strong liquidity are better prepared to handle unexpected events, economic downturns, or changes in market conditions. Sufficient liquidity also provides flexibility and the ability to take advantage of strategic opportunities.
A company can pursue expansion initiatives, acquire other businesses, or make capital investments with readily available cash or liquid assets. This enables companies to act swiftly when favourable opportunities arise, enhancing their competitive position.
Adequate liquidity is also essential for maintaining investor confidence. Investors prefer companies with strong liquidity positions because it indicates financial strength and stability. Liquidity allows companies to honour dividend payments, undertake share buybacks, and provide a buffer against potential financial distress.
What is the difference between cash flow and liquidity?
Cash flow refers to the movement of cash in and out of a company over a specific period. Cash flow is a dynamic measure that reflects the timing and magnitude of cash inflows and outflows. Positive cash flow is generally seen as a positive sign, meaning a company generates more cash than it is spending.
Liquidity, however, measures the company’s ability to access cash quickly and cover its immediate liabilities. Liquidity is a snapshot of a company’s ability to meet its financial obligations at a specific point in time, whereas cash flow reflects the actual movement of cash over time.
Both cash flow and liquidity are important for assessing a company’s financial health and stability.
How to measure a company’s liquidity
Analysts and investors use several key metrics to assess the liquidity of a company. These include the current ratio, quick ratio, and cash ratio.
Current ratio
The current ratio compares a company’s assets (such as cash, accounts receivable, and inventory) to its current liabilities (accounts payable and short-term debt). A higher ratio indicates a greater ability to cover short-term obligations.
We can calculate the current ratio with the following formula:
Current ratio = (current assets) / current liabilities
While the current ratio is a widely used measure of liquidity, it has certain limitations to keep in mind. For example, it treats all existing assets and liabilities as if they will be realised or settled within the same operating cycle.
However, not all current assets can be easily converted into cash or used to meet short-term obligations. For example, inventory may take time to sell, and there can be delays in the collection of accounts. Similarly, not all current liabilities are due immediately.
Quick ratio
The quick ratio (also known as the ‘acid test ratio’) considers only the most liquid current assets (such as cash, marketable securities, and accounts receivable) and compares them to current liabilities.
The quick ratio excludes inventory and prepaid expenses as these assets may take time to sell or utilise. They bolster a company’s balance sheet on paper but, in practice, can’t be readily sold to fund debt repayments. In this way, the quick ratio is a more conservative metric.
We can use several formulas to calculate the quick ratio of a company. Here are a few examples:
- Quick ratio = (liquid assets) / due liabilities
- Quick ratio = (current assets – inventory – prepaid expenses) / current liabilities
- Quick ratio = (cash & cash equivalents + marketing securities + accounts receivable) / current liabilities
The quick ratio benefits companies that rely heavily on inventory, as it addresses the potential illiquidity associated with slow-moving or obsolete inventory. It also helps when we evaluate companies with unpredictable or fluctuating sales cycles, as it focuses on assets that can be readily converted into cash to meet immediate financial obligations.
A higher quick ratio implies a stronger liquidity position, suggesting that a company has a larger proportion of highly liquid assets relative to its current liabilities. Generally, a quick ratio above 1.0 is considered favourable, indicating that a company can fully cover its short-term obligations without relying on the sale of inventory.
Cash ratio
The cash ratio assesses a company’s ability to meet short-term obligations using only cash and cash equivalents without considering other current assets.
The formula for calculating the cash ratio is:
Cash ratio = (cash + cash equivalents) / current liabilities
The cash ratio provides a more stringent measure of liquidity than other ratios. Considering only cash and cash equivalents eliminates the potential variability and illiquidity associated with other current assets like marketable securities.
The cash ratio is particularly useful for assessing a company’s ability to meet its immediate obligations when other current assets may not be easily convertible into cash, such as during periods of financial distress or economic uncertainty. It provides insight into a company’s cash position and ability to address short-term financial obligations without relying on selling other assets.
How should we use liquidity ratios?
We can use liquidity ratios as part of an overall analysis and assessment of a company’s financial health and investment potential. They can be used as a gauge of the financial stability of a company. Higher ratios imply a stronger ability to cover short-term obligations and manage unexpected financial challenges.
We can also use liquidity ratios to compare companies within the same industry or sector. A company can be benchmarked against its peers. This comparison can provide insights into a company’s efficiency in managing its working capital and liquidity compared to its competitors.
Conservative investors who prioritise capital preservation and short-term stability will likely prefer companies with strong liquidity ratios. On the other hand, growth-oriented investors may be willing to accept lower ratios if they believe the company has significant growth potential and can generate higher returns.
It’s important to note that liquidity ratios alone do not provide a complete picture of a company’s financial health or investment potential.
They provide a snapshot of a company’s short-term liquidity position. A comprehensive investment analysis requires a broader assessment of factors such as profitability, cash flow generation, industry dynamics, competitive advantages, and management quality.