Financial liquidity

What is financial liquidity?

Financial liquidity refers to the difficulty of converting assets into cash. Assets such as stocks and bonds are very liquid because they can be converted into cash within a few days. However, large assets such as real estate, plant and equipment are not so easy to convert into cash. For example, your checking account is liquid, but if you own land and need to sell it, it may take weeks or months to liquidate it, reducing its liquidity.

Understand financial liquidity

cash It is the most liquid asset. However, some investments are easily converted into cash, such as stocks and bonds. Since stocks and bonds are very easy to convert into cash, they are often referred to as current assets.

Investment assets Those that take longer to convert to cash may include preferred stocks or restricted stocks, which usually have contracts that specify how and when they are sold.

Key points

  • Financial liquidity refers to the difficulty of converting assets into cash.
  • Assets such as stocks and bonds are very liquid because they can be converted into cash within a few days.

Coins, stamps, art and other collectibles If investors want the full value of the project, liquidity is lower than cash. For example, if an investor wants to sell to another collector, if they wait for a suitable buyer, they may get the full value. However, if you need cash, you can sell the item at a discount through a distributor or broker.

Land, real estate or buildings They are considered the least liquid assets because it can take weeks or months to sell them.

Before investing in any asset, it is important to keep in mind the liquidity level of the asset, as converting back to cash may be difficult or take time. Of course, in addition to selling assets, you can also obtain cash through asset borrowing. For example, a bank lends to a company, using the company’s assets as collateral to protect the bank from default. The company receives the cash, but must repay the original loan amount and interest to the bank.

Market liquidity

Market liquidity refers to the ability of the market to allow assets to be bought and sold easily and quickly, such as a country’s financial market or real estate market.

If the stock can be bought and sold quickly and the transaction has little effect on the stock price, then the stock market is liquid. Company stocks traded on major exchanges are generally considered liquid.

If the exchange volume is large, the price per share provided by the buyer (buying price) and the price the seller is willing to accept (selling price) should be close to each other. In other words, the buyer does not have to pay more to purchase the stock and can easily liquidate it. When the spread between the buying price and the selling price widens, the market becomes more illiquid. For illiquid stocks, the spread may be even greater, reaching several percentage points of the transaction price.

The time of day is also important. If you trade stocks or investments after get off work, there may be fewer market participants. In addition, if you are trading currencies and other overseas instruments, the liquidity of the euro may decrease during Asian trading hours, for example. Therefore, the bid-ask spread may be much wider than when you trade Euros during European trading hours.

Financial liquidity of markets and companies

A company’s liquidity usually refers to the company’s ability to use its current assets to repay current or short-term liabilities. A company is also measured by the amount of cash it generates in excess of its liabilities. The remaining cash that the company must expand its business and pay its shareholders through dividends is called cash flow. Although this article will not delve into the advantages of cash flow, having operating cash is critical to the company’s short-term and long-term expansion.

Below are three commonly used ratios that are used to measure the liquidity of a company or the degree to which a company liquidates its assets to meet its current obligations.

Current ratio (Also called the working capital ratio) measures a company’s liquidity and is calculated by dividing its current assets by current liabilities.the term current Refers to short-term assets or liabilities that have been consumed (assets) and paid off (liabilities) for less than a year. The current ratio is used to provide a company’s ability to repay its liabilities (debts and accounts payable) with its assets (cash, securities, inventory, and accounts receivable). Of course, industry standards vary, but ideally, companies’ ratio should be greater than 1, which means they have more current assets and current liabilities. However, for accurate comparison, it is important to compare the ratio with similar companies in the same industry.

Quick ratio, Sometimes called Acid test ratio, The same as the current ratio, but the ratio does not include inventory. Inventory is deleted because it is the most difficult to convert to cash compared to other current assets (such as cash, short-term investments, and accounts receivable). In other words, inventory does not flow like other current assets. From a liquidity perspective, a ratio value greater than 1 is generally considered good, but it depends on the industry.

Operating cash flow ratio A measure of the extent to which the cash flow generated by the company’s operations covers current liabilities. The operating cash flow ratio is a measure of short-term liquidity by calculating the number of times a company can use cash generated during the same period to repay its current debt. This ratio is calculated by dividing operating cash flow by current liabilities. The higher the number, the better, because it means the company can repay its current liabilities more often. An increase in the operating cash flow ratio is a sign of a good financial situation, and a company with a declining ratio may have liquidity problems in the short term.

Bottom line

Liquidity is important in markets, companies and individuals. Although the total value of the assets owned may be high, if the assets cannot be easily converted into cash, the company or individual may encounter liquidity problems. For companies that provide loans to banks and creditors, lack of liquidity may force companies to sell assets they don’t want to liquidate to repay short-term debts. Banks play an important role in the market by providing cash to companies while holding assets as collateral.

If investors want to be able to enter and exit investments easily and smoothly, market liquidity is crucial. Therefore, before opening a position, you must ensure that you monitor the liquidity of stocks, mutual funds, securities or financial markets.

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