What is Liquidity?
In financial markets, liquidity refers to how quickly an investment can be sold without impacting its price. The more liquid an investment is, the more quickly it can be sold (and vice versa). All else being equal, more liquid assets trade at a premium and illiquid assets trade at a discount.
In accounting and financial analysis, a company’s liquidity is a measure of how easily it can meet its short-term financial obligations.
Ranking of Market Liquidity (Example)
Below is an example of how many common investments would typically be ranked in terms how quickly they can be turned into cash (of course, the order may be different depending on the circumstances).
- Foreign Currency (FX)
- Guaranteed Investment Certificates (GICs)
- Government Bonds
- Corporate Bonds
- Stocks (publicly traded)
- Commodities (physical)
- Real Estate
- Private Businesses
As you can see in the list above, cash is, by default, the most liquid since it doesn’t need to be sold or converted (it’s already cash!). Stocks and bonds can all typically be converted to cash in about 1-2 days, depending on the size of the investment. Finally, slower-to-sell investments such as real estate, art, and private businesses take much longer to convert to cash (often months or even years).
Items on a company’s balance sheet are typically listed from the most to the least liquid. Therefore, cash is always listed at the top of the asset section, while other types of assets such as Property, Plant & Equipment (PP&E) are listed last.
In finance and accounting, the concept of a company’s liquidity is its ability to meet its financial obligations. The most common measures of liquidity are:
- Current Ratio – Current assets minus current liabilities
- Quick Ratio – The ratio of only the most liquid assets (cash, accounts receivable, etc.) compared to current liabilities
- Cash Ratio – Cash on hand relative to current liabilities
Liquidity Example (Balance Sheet)
As you can see in the image, Amazon’s assets are separated into two categories, current asset and non-current assets (everything else).
Current assets are listed as follows:
- Marketable securities (These would include publicly traded stocks, bonds, and other investments)
- Inventories (Products, finished goods, raw materials, etc. that can be sold)
- Accounts receivable (Cash owed from sales to customers on credit)
For most companies, these are four of the most common current assets. Their liquidity, however, can vary. For many companies, accounts receivable is more liquid than inventories (meaning the company expects to receive payment from customers faster than it takes to sell products in inventory).
Current liabilities are listed as follows:
- Accounts payable (money owed to vender and suppliers)
- Accrued expenses and other (money the company expects to owe to vendors and suppliers in the future)
- Unearned revenue (also called deferred revenue)
To learn more, check out CFI’s Advanced Financial Modeling Course on Amazon.
CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful: