What is financial liquidity? What is market liquidity?

 

What is financial liquidity?

What is market liquidity?

How to identify market liquidity?

What are the key components of market liquidity?

Why is financial liquidity important?

Why is market liquidity important?

1. Meaning

Financial liquidity means the ability to convert your assets into cash. It refers to the ease with which you can get cash by disposing of your assets.

Among all assets, cash is the most liquid asset.

Some assets like stocks, bonds can readily be converted into cash, so they are highly liquid assets.

While some assets like real estate, buildings, plants, machinery, and equipment can not readily be converted into cash, so they are less liquid assets. It may take weeks or months to locate buyers in these cases.

2. What is market liquidity?

Market liquidity refers to the market's ability to buy or sell your assets in the country's financial market or real estate market.

The market for your company's stock is considered liquid if its shares can be bought and sold quickly and easily. And such a buy-sell transaction has a negligible effect on the stock's price. It means that buy and sell transactions should occur in the financial market at a price that is equal or nearly equal to the quoted market price.

3. How to identify market liquidity?

If a stock exchange has a high volume of trade, the bid price and the ask price for a stock should be close to each other. Bid price means the price offered by the buyer and ask price means the price accepted by the seller. In this case, the market is considered to be liquid.

If we talk the other way, the buyer would not have to pay more to buy the stock. The seller would quickly find a buyer to sell the stock easily without having to cut the prices to make it attractive. Then the market is liquid.

When the spread between the bid and ask prices widens, the market becomes more illiquid.

 What are the key components of market liquidity?

The size of the bid-ask is often considered as one of the measurements of liquidity, although it is not the sole measurement. In general, there are four components of liquidity viz.

a)   Tightness

b)   Depth

c)    Resiliency, and

d)  Diversity

The first three components were identified by Kyle (1985) and the last one 'diversity' by Persaud (2001).

Tightness means the bid-ask spread. As the spread between bid-ask widens the market becomes more illiquid.

Depth means the volume of transactions necessary to move prices.

Resiliency means the speed with which prices return to equilibrium following a large trade.

Diversity means the degree of diversity among market participants according to their opinions on the market and desired trade.

Persaud argues that lack of diversity can lead to liquidity black holes. These are the conditions where liquidity dries up, and a decrease in prices brings out more sellers or an increase in prices brings out more buyers, further frustrating the price move. This is the exact opposite of what would be expected in a regularly functioning market, where, a price decline would bring out bargain hunters. Perhaps the classic example of a liquidity black hole is the 1987 stock market crash.

Examples of assets that tend to be liquid include foreign exchange, stocks traded on the stock exchange, Treasury bonds. Assets that are often illiquid include limited partnerships, thinly traded bonds, or real estate.

4. What is financial liquidity in companies and markets?

Liquidity in respect of companies means the ability of the company to meet its shorter-term obligations from its current assets.

A company is considered to be liquid if it is able to generate cash flows over and above its liabilities.

Apart from meeting the obligations, the company needs cash for the acquisition of non-current assets, expansion of the company, to pay dividends to the shareholders.

Here are the most common ratios to measure the company's liquidity.

a)   Current Ratio/Working Capital Ratio

b)   Quick Ratio/Acid Test Ratio

c)    Operating Cash Flow Ratio/Current Liability Coverage Ratio

These are discussed in detail as follows:

a)   Current Ratio/Working Capital Ratio

It measures the company's liquidity position. It shows how well the company is equipped to meet short-term obligations from short-term assets. The current assets divided by the current liabilities give the figure of the current ratio.

What indication is given by the Current Ratio?

-A current ratio of greater than one indicates that the company has sufficient cash to meet its shorter-term obligations.

-A current ratio of less indicates some concern over working capital issues.

 

b)  Quick Ratio/Acid Test Ratio

It is similar to the current ratio except that it removes inventory from the current assets.

Inventory is excluded because it is not as liquid as other current assets like cash, short-term investments, and account receivables.

What indication is given by the Current Ratio?

-A current ratio of greater than one indicates that the company has sufficient cash to meet its shorter-term obligations.

-A current ratio of less indicates some concern over working capital issues.

        But this is industry-dependent.

c)    Current liability coverage ratio/Operating cash flow ratio

This ratio shows the relationship between the operating cash flow and the current liabilities of the company. The operating cash flow divided by the company's current liabilities gives the figure of the current liability ratio.

What indication is given by the current liability coverage ratio?

-The current liability ratio of less than 1 indicates the company is not generating enough cash to meet its current obligations and is a warning signal of bankruptcy.

5. Why is financial liquidity important?

Liquidity is the ability to convert an asset into cash easily and without losing money against the market price. Financial liquidity is important for learning how easily a company can pay off its short-term liabilities and debts.

6. Why is market liquidity important?

Market liquidity is important because it impacts how quickly you can open and close positions.

In a liquid market, the buyer would not have to pay more to buy the stock and the seller would quickly find a buyer to sell the stock easily without having to cut the prices to make it attractive.

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