Liquidity is a term used to describe how quickly and easily an asset or security may be converted into cash. From real estate holdings to shares of corporate stock, degrees of liquidity vary significantly in relation to a broad spectrum of factors. Public interest, supply/demand levels, and macroeconomic cycle are a few broader issues that determine an asset's relative liquidity.
Aside from applications in the marketplace, liquidity is also a valuable consideration in both personal and corporate finance. It is frequently used in reference to whether or not an entity is able to meet any financial obligations. Ratio analysis is a common way of measuring financial liquidity, and it's an integral aspect of balance sheet and income statement analysis.
Currency, commodity and equity products exhibit varying degrees of liquidity due to any number of fundamental factors. Time of day, news cycle and institutional participation all contribute to the number of buyers and sellers actively engaging the market of a security.
- Tight Bid/Ask Spreads: Trading liquid markets is more affordable due to consistently tight bid/ask spreads.
- Limited Slippage: The probability of having an order filled at a desirable price increases in a liquid market.
- Pricing Volatility: Enhanced participation rates typically lead to fluctuations in pricing, thus creating trading opportunities.
In practice, high degrees of market liquidity promote trade-related efficiency. Given this consideration, many strategies are designed specifically to engage those markets that exhibit consistently strong participation. The following are two indicators used to identify the markets/products most likely to facilitate efficient trade:
- Open Interest: Open interest is the number of outstanding shares or contracts in the market of a security at a specific point in time. This indicator is used to project future participation levels and quantify the activity present in a market.
- Traded Volumes: Traded volumes are the number of shares, lots or contracts that have changed hands for a given period. For instance, the forex boasts a tremendous daily traded volume in the trillions of pounds, which ensures robust market liquidity.
The general rule of thumb relating liquidity to volume and open interest is as follows: the greater the volume and open interest, the more liquid the market.
Perhaps the most important aspect of liquidity is how it impacts value. In the event that an asset or security is not readily exchangeable for cash, it is deemed illiquid and loses value. This can have dire consequences for the asset holder (seller) as any compensation received in an exchange is not likely to equal the asset's full value. Illiquid assets or markets are not ideal for active traders, as efficiency is compromised due to wide bid/ask spreads and high degrees of slippage stemming from limited participation.
Measuring Liquidity: Ratio Analysis
While open interest and traded volumes are used to determine a market's liquidity, ratios are frequently used as measurements for individuals and companies. These metrics relate assets and cash to liabilities, creating a picture of solvency or insolvency. Ratios play an integral role in fundamental analysis, especially as it pertains to the trade of equity products.
The following are three commonly used financial liquidity ratios:
- Current Ratio: (Current Assets)/(Current Liabilities)
- Acid-Test Ratio: (Cash + Accounts Receivable+Cash Equivalents)/(Current Liabilities)
- Cash Ratio: (Cash + Cash Equivalents)/(Current Liabilities)
The consequences for a company or individual being deemed illiquid can be substantial. In both cases, credit worthiness is negatively impacted. In the case of corporate stocks, share prices can plummet due to insolvency. For individuals, securing loans or lines of credit becomes exponentially more difficult.
Liquidity is a key element of both active trading and finance. In the marketplace, it promotes efficient trade and is vital to the success of a broad spectrum of strategies. As it pertains to traditional financial theory, it is the ability of an entity to meet its obligations. In either case, high degrees of liquidity are viewed as being positive characteristics, promoting efficiency and solvency.