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Category — Analytical Metrics
By Konstantin Vasilev Member of the Board of Directors of Cbonds, Ph.D. in Economics
Updated July 1, 2023

What is liquidity?

Liquidity is a measure of how quickly and smoothly an asset or security can be converted into cash without significantly impacting its market price. Cash, being the most liquid asset, can be readily accessed and utilized.

The level of liquidity directly influences the ease and efficiency of converting an asset into cash. Highly liquid assets can be quickly and effortlessly transformed into cash, while less liquid assets require more time and effort, potentially incurring higher costs.


Understanding liquidity: Market liquidity and accounting liquidity

Liquidity refers to the degree to which an asset can be quickly bought or sold in the market at a price reflecting its intrinsic value. Cash, being the most liquid asset, can be readily converted into other assets. On the other hand, illiquid assets, such as certain real estate properties or privately held securities, face challenges in terms of their ease of conversion.

To assess liquidity, various factors come into play. Liquidity ratios like the cash ratio, current ratio, and acid test ratio provide insights into a company’s ability to meet its short-term obligations using its current assets. Additionally, trading volume and stock liquidity in the stock market are indicators of market liquidity.

Market liquidity

Market liquidity refers to the extent to which a market, such as a country’s stock market or a city’s real estate market, allows assets to be easily bought and sold at stable and transparent prices. An illiquid asset is one that cannot be readily converted into cash due to limited market demand or difficulty in finding buyers and sellers.

In a liquid market, there is ample trading activity, facilitating the swift exchange of assets between buyers and sellers. This high liquidity provides assurance of an asset’s ability to be converted into cash without a significant impact on its market price. Liquid stocks, marketable securities, and money market accounts are examples of assets that are readily tradable in a liquid market.

Investors often diversify their holdings by creating an investment portfolio that includes a mix of liquid investments. Liquidity risk refers to the potential for an investment or market to experience reduced liquidity, which can impede the ability to quickly buy or sell assets.

Accounting liquidity

Accounting liquidity refers to the evaluation of an individual’s or company’s ability to meet their financial obligations with the liquid assets available to them—their ability to pay off debts as they come due. It involves assessing the conversion of assets into cash flow.

In the context provided, if an individual holds illiquid stocks, it may adversely impact their ability to pay off debts promptly. Low liquidity of these stocks can pose challenges in converting them into cash at a reasonable price. It is crucial to have enough liquid assets to cover current liabilities, which are the financial obligations due in the short term.

To assess accounting liquidity, one can consider the quick ratio, which compares liquid assets to current liabilities. This ratio provides insights into the company’s liquidity position and its capacity to meet immediate financial obligations. Additionally, the liquidity of a stock can be evaluated by analyzing factors such as its trading volume, bid-ask spread, and the ease with which it can be bought or sold.

Why is liquidity important?

When markets lack liquidity, the process of selling or converting assets and securities into cash becomes challenging. Consider a scenario where you possess a rare and valuable family heirloom, assessed at $150,000. However, if there is no active market, meaning there are no buyers interested in your item, its appraised value becomes irrelevant since it cannot be sold anywhere close to that price. Such illiquid assets may require the involvement of an auction house acting as a broker to locate potential buyers, which not only consumes time but also incurs additional costs.

On the other hand, liquid assets can be effortlessly and swiftly sold at their full value, incurring minimal costs. Maintaining enough liquid assets is crucial for companies to fulfill their short-term obligations, such as paying bills and meeting payroll. Failure to do so can trigger a liquidity crisis, potentially leading to bankruptcy.

Having liquidity in the markets ensures the smooth functioning of transactions, providing buyers and sellers with the flexibility to convert their assets into cash when needed. It enables the efficient allocation of resources and safeguards against financial distress caused by the inability to fulfill immediate financial commitments.

How is liquidity measured?

Financial analysts closely examine a company’s capacity to utilize liquid assets for fulfilling short-term obligations. Generally, these analysts prefer ratios greater than one when assessing liquidity.

Current Ratio

The current ratio is a straightforward and less stringent measure. It compares current assets, which can be reasonably converted to cash within a year, with current liabilities. The formula for the current ratio is:

Current Ratio = Current Assets ÷ Current Liabilities

Quick Ratio (Acid-Test Ratio)

The quick ratio, also known as the acid-test ratio, is slightly more stringent. It excludes inventories and other current assets that are less liquid compared to cash and cash equivalents, accounts receivable, and short-term investments. The formula is:

Quick Ratio = (Cash and Cash Equivalents + Short-Term Investments + Accounts Receivable) ÷ Current Liabilities

Acid-Test Ratio (Variation)

A variation of the quick/acid-test ratio subtracts inventory from current assets, making it somewhat more lenient. The formula is:

Acid-Test Ratio (Variation) = (Current Assets - Inventories - Prepaid Costs) ÷ Current Liabilities

Cash Ratio

The cash ratio is the most stringent among liquidity ratios. It solely considers cash or cash equivalents as liquid assets, excluding accounts receivable, inventories, and other current assets. The cash ratio evaluates an entity’s ability to maintain solvency in worst-case scenarios, recognizing that even highly profitable companies can face difficulties without sufficient liquidity to respond to unforeseen events. The formula is:

Cash Ratio = Cash and Cash Equivalents ÷ Current Liabilities


  • What is an example of market liquidity?

  • What are the most liquid assets or securities?

  • Is more liquidity good or bad?

  • Why are some stocks more liquid than others?

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