If you totaled all of your assets right now, that number would probably be bigger than you expect. Your car, for instance, has value, but it doesn’t feel like value you can access. If you were willing to sell it quickly, it would still take a couple weeks to convert your car into cash.
The difference between the assets you can access quickly and the ones that take a long time to convert into cash is a concept called liquidity. It’s important to understand liquidity in terms of your personal finances and your investments.
What is Liquidity?
As of the end of 2019, Bill Gates is worth $110 billion. He could buy anything he wants at a moment’s notice, right? Actually, that’s probably not the case.
Most of us keep our net worth in a few places: cash accounts, marketable securities (investments we can sell quickly), and basic property like cars and maybe a house. But Bill Gates’ portfolio looks very different.
At Bill’s level of wealth, his financial worth is spread through an elaborate portfolio of securities and investments. He owns a massive portion of Microsoft, of course, along with stakes in other businesses, investment funds, and charities.
But Bill can’t drop into his bank and withdraw a billion dollars. He probably can’t even access a million dollars at a moment’s notice. If he needs that kind of money, he most likely has to speak to his accountant to get the funds shifted around. (We don’t know for sure how Bill manages his finances, but this is how the super wealthy typically operate.)
In fact, a majority of Bill’s worth could take months or years to access. It’s not like he could sell his stake of Microsoft in a day. The sudden supply dumped into the market would crash the price, not to mention the panic he would cause as every investor asked, “Why is Bill bailing out of his own company?”
So while Bill is technically worth $110 billion, he has a lot less than that in his pocket at any given time. The portion he can access quickly are his liquid assets.
Liquidity Explained
Liquidity is the ability to buy or sell an asset quickly in the market at a price that reflects its value. Essentially, it refers to how easily you can convert something you own to cash.
Cash is considered the most liquid asset because it’s easily tradable (it’s already cash!) and everyone takes it. Tangible items like equipment and real estate aren’t very liquid because they can take some time to sell. Other assets, like stocks and bonds, fall somewhere in the liquidity spectrum.
For example, let’s say you want to buy a living room set that costs $2,000. The easiest way to obtain it is by trading cash. The furniture dealer will happily accept cash because it’s also easy for him to spend.
But let’s say you don’t have $2,000 in cash. Instead, you have Star Wars collectibles worth $2,000. Even though the value of your collection matches the value of the furniture, it’s unlikely the furniture dealer will accept it. You would have to convert the collection into cash before you could buy the furniture, which can take years for niche products. Extra time and steps makes the asset less liquid.
It’s important to note that liquidity is based on the market rate of assets, not a heavily discounted rate you accept to sell something quickly. The Star Wars collection doesn’t become more liquid just because you’re willing to sell it for $500.
Liquidity in Investing
As an investor, you’ll want to look at the liquidity of any business you consider investing in. A business with few liquid assets isn’t able to pay its short-term obligations, especially during a crisis. A business with healthy liquidity has enough cash (or assets easily converted into cash) to keep itself afloat.
That said, there’s an upper limit to healthy liquidity. If a business has too much cash on hand, it’s not investing in revenue-generating products as efficiently as it could.
Accounting Liquidity and Liquidity Risk
Accounting liquidity is a measure of how easily a company can meet its financial obligations us. Basically, accounting liquidity answers the question, “Can this company pay its debts as they come due?”
Liquidity risk occurs when a company can’t meet its short-term debts. This means it doesn’t have enough assets to convert into cash to pay its obligations. It has to sell its assets, bring in more revenue, or find some other way to raise cash and pay its debt obligations.
The 2008 financial crisis is an example of a serious liquidity risk. Investment banks teetered on the edge of going out of business because they didn’t have enough cash to pay their short-term debts. If the liquidity risk was left unchecked, the problem would have spiraled down to small commercial banks. The U.S. government had to inject cash into the banking sector so they could meet their obligations.
As an investor, make sure you have enough liquidity to meet your obligations before investing in long-term assets, otherwise you could end up paying a hefty price to convert those assets to cash.
Liquidity of Different Assets
Cash is the most liquid asset because you don’t have to convert it in order to spend it. You can use it to pay expenses immediately, and it always maintains its value.
Assets like stocks and bonds are generally liquid because they can be sold within days. Highly desirable stocks often sell in minutes, so they are quite liquid. Less desirable stocks are still liquid because you can sell them quickly, but less liquid than a trendy company. It could take several days to find a buyer for the shares of an obscure, over-the-counter company.
Fixed assets like land, vehicles, real estate, or buildings are considered the least liquid (or most illiquid) assets because of the length of time it takes to convert them to cash. A piece of commercial property could take years just to find a buyer, and another year to negotiate a sale.
Everything else falls in between those two categories. The liquidity of personal and commercial property depends on how quickly you can sell them. Generic office desks and computers are fairly liquid, but highly customized machinery is illiquid because there aren’t many buyers.
Assets can be less liquid if you incur a cost to access them. For example, a certificate of deposit is just cash in a high yield savings account, but it comes with a penalty for withdrawing early. Even though you can withdraw it at any time, the fee to do so makes it less liquid.
Make sure you understand the liquidity of an asset before you invest. Determine how long it would take to sell the asset if you needed to raise cash. We encourage everyone to build a cash emergency fund so you’re always at least partially liquid. This is a key way to protect yourself against unforeseeable problems.
Liquidity Ratios
Investors use several ratios to evaluate a company’s liquidity and determine its liquidity risk. These tools compare the company’s assets and liabilities to determine their ability to meet their financial obligations.
These ratios rely on a company’s current assets and current liabilities. “Current,” in this case, refers to one year. Current assets are assets that can be converted to cash within a year. Current liabilities are liabilities that need to be paid within a year.
Current Ratio
The current ratio compares all of a company’s current assets to its current liabilities. Current assets include cash (which is already liquid), securities that can be sold on the market, accounts receivable (if they can be collected within a year), prepaid expenses, and inventory.
Formula: Current Ratio = Current Assets / Current Liabilities
Quick Ratio
The quick ratio is similar to the current ratio, except it doesn’t include inventory or prepaid expenses as current assets because they are harder to convert into cash. This ratio is better for businesses who don’t keep a lot of inventory or can’t sell their inventory reliability within a year.
Formula: Quick Ratio = (Current Assets - Inventory) / Current Liabilities
Cash Ratio
The cash ratio is a conservative formula that only compares cash and readily convertible investments to current liabilities. This ratio measures how well a company can pay its liabilities with just cash.
Formula: Cash Ratio = (Cash + Marketable Securities) / Current Liabilities
The Bottom Line
Does this mean you should keep all of your assets in cash to maximize your liquidity? Absolutely not!
As a consumer, you only need to be liquid enough to cover your short-term expenses. That is, you need enough liquid assets (like a cash emergency fund) to buy you enough time to sell your non-liquid assets at market price (if it came to that).
However, if you keep more of your assets in cash then you need for your short-term expenses, you will fail to maximize the earning potential of that money. Every penny you don’t need as cash should be used to invest so your nest egg grows.
The same concept applies to businesses. Managers, creditors, and investors want businesses to have enough liquidity to cover their short-term financial obligations. But not too much! Too much cash on hand means the business isn’t investing in more revenue-generating activities.
In a sense, liquidity is a measure of safety. It tells you how well you or a business can manage a financial problem. Whether you’re planning your own finances or evaluating a potential investment opportunity, it’s always important to understand liquidity.
