Role of Liquidity in market fundamentals: Liquidity is the feature of the financial market with which an individual can convert security or an asset easily with no time boundaries. There is no radical change in the value of an asset after conversion.
It involves the trade-off between the amount on which one wishes to sell an asset, and quick is this procedure of sale. The compromise is mild in case of the liquid market, where one can sell briskly at a reasonable price. Whereas the illiquid market offers comparatively low cost in case, one wants to sell urgently.
So, liquidity of an asset measures the frequency of buying and selling a good or service. Let’s take an example of this:
If a person wishes to purchase a refrigerator costing $1,000, cash will be the most suitable asset for buying it. But she does not have money for it; instead, she has a collection of rare books worth $1,000. Now the major difficulty she will face is finding a person who can exchange refrigerator with books. Instead of this she can sell books in the market, get money and buy a fridge.
She could purchase it any time but, if she wants to sell these book instantly, she will have to sell books on discount. In this case, the books can be seen as an example or illiquid market.
Another commonly used word in the financial market is liquidation. It refers to the process of exchanging more liquid asset with the less liquid asset. Often, this means selling an asset with low liquidity for cash.
An asset’s liquidity fluctuates depending on circumstances. Ease of selling an asset at one point in the year may be different from selling it on a different date of the same year.
Cash or money is the most favourable liquid asset. It can be exchanged instantly with goods and services without any depreciation in its value. Moreover, it eliminates waiting for a suitable buyer as money is accepted globally. It can fulfil all need such as selling, buying goods, payments of debt and meeting immediate needs and wants. Tangible items are less liquid as compared to cash.
Types of Liquidity
It has two types:
1) Market liquidity
It defines the extent to which city’s real estate market, the country’s stock market allows buying and selling of goods at a stable price. In the above example, the exchange market is so illiquid that it does not exist. On the contrary to this, the stock market has high market liquidity, but less than the real estate market.
Apart from these other markets, liquidity depends on open exchanges available and their size. It includes market such as contract, commodity, derivatives and currency.
The seller cannot dominate a high volume market. The difference between the price seller demands and buyer ask are relatively close and suitable for both parties. But as spread grows, the market becomes more illiquid.
2) Accounting Liquidity
It is the measure of the ability of the debtor to pay back its debts when they are needed. For this, they can use available assets. These assets need to be a liquid asset.
Accounting Liquidity is the common word which almost every start-up, companies or fully establish business come across. It has an immense potential to generate profit; for this reason, the person who offers loan to these institutions settles debt amount before confirming the loan.
How To Measure Liquidity?
There are various ratios whose data can be taken as a reference value to measure liquidity.
1) Current Ratio– It measures the assets that can be converted into cash in one year or in a simple way; it measures the value of existing holdings against present liabilities. It is the simplest ratio with fewer rules.
The formula for Current Ratio is:
Current Ratio = Current Assets / Current Liabilities
2) Quick Ratio (Acid-test ratio) – It is more bounded by rules. It excludes current assets, inventories, short-term investments, receivables exchange, cash equivalents and other assets which are not liquid as money or cash.
The formula for Quick Ratio is:
Quick Ratio = (Cash equivalents and cash + Accounts Receivable + Short-Term Investments) / Present Liabilities)
3) Acid-Test Ratio (Var) – Deduction of inventory from existing assets, to make the result more precise.
The formula for Acid-Test Ratio is-
Acid-Test Ratio (Var) = (existing Assets – Prepaid Costs -Inventories) / Present Liabilities
4) Cash Ratio– It is the most exact ratio for liquidity. It strictly defines an asset as cash equivalents or cash. It excludes receivable accounts, other current assets and inventories. Reflects the ability of an entity to remain solvent at the time of crisis or emergency. It is beneficial for companies to avoid any unforeseen loss.
The formula for Cash Ratio is:
Cash Ratio = (Cash Equivalents and Cash + Short-Term Investments) / Present Liabilities
Examples of Liquidity
The most liquid asset in the financial market is equity in terms of investment. But equity creation in all cases differs according to their trade price on the stock exchange. In another way, one can say that they take a greater interest from investors and traders.
The daily trade volume of stock plays a vital role in the identification of liquid share. This daily volume can be in millions or more.
Words of Wisdom
The market is endless, and so are its concepts and strategies. It isn’t easy to understand every idea deeply. One should try to grab things which are essential and useful hence, leaving others.
Go through books, articles and news channels; the best way to start and enhance knowledge.