Terms Beginning With 'l'

Liquidity

  • January 07, 2020
  • Team Kalkine

Financial pundits have often stated that the most important thing in business is liquidity. But what is liquidity? Let us deep dive-

What Is Liquidity?

As the term suggests, liquidity is the quality of being liquid or flowing free like water. In the business sense, liquidity refers to the amount of money that is easily accessible for spending and investment. As deciphered, the concept related to quick access to cash.

Some experts even regard liquidity to be the amount of cash and cash equivalents. Another way to look at the concept is this- both individuals and businesses hold assets or security. Liquidity refers to the ease with which these may be bought or sold in the market for conversion into cash. It involves the trade-off between the price at which a particular asset can be bought, and how quickly it can be sold.

Getting the basics- In a liquid market, the trade-off is mild, which means that assets can be sold quickly without having to accept a significantly lower price. On the contrary, in a comparatively illiquid market, an asset is required to be discounted to sell quickly.

Why Is Liquidity Important?

The answer to the above is simple- Liquidity may be the most effective silver lining when one encounters the need for urgent cash, which can occur anytime.

Liquidity is the ability to get one’s money whenever one needs it. It can be looked upon as an emergency savings account or cash lying with someone that can be easily accessed in case of any unforeseen happening or any financial setback. Besides, liquidity plays a vital role as it allows individuals and businesses to seize opportunities. This is because if one has cash and easy access to fund, it is easier to seize any opportunity that comes along.

Financial experts often stress upon the importance of liquidity when one is planning investments. It is crucial to factor liquidity in financial plans to ensure that one has secured its long-term as well as short-term needs. This further should ensure that one does not utilize/ incur a loss to discount their long-term investments when in need.

Discussing the importance of liquidity from an investment perspective-

  • It plays a critical role in balancing one’s portfolio with trade-offs between risk and return.
  • It may help accelerate transactions, as having liquid funds reduces the time-lapse from when the asset is put for sale and by the time one finds a buyer.
  • Liquid funds are known to retain their value when they exchange hands, unlike many illiquid funds.

ALSO READ: What Is Market Liquidity?

Features Of A Liquid Asset

A liquid asset may have some or all of the following features-

What Are The Measures Of Liquidity?

There are two main measures of liquidity-

  • Market Liquidity- Indicates market situation where assets may be purchased or sold off quickly. This type of liquidity is particularly evident in the case of real estate, the stock market or financial market. Markets for real estate are typically far less liquid than stock markets. The shares traded on stock exchanges are usually found to be liquid due to a large number of buyer and seller available, which leads to easy conversion to cash.
  • Accounting Liquidity- The comfort with which a business or an individual can meet financial obligations through liquid assets is accounting liquidity. It requires a comparison of the liquid assets held by the business or an individual to that of current liabilities in a financial year. The current ratio and cash ratio measure this.

 

What Are The Different Liquidity Ratios?

Businesses and individuals use liquidity ratios to evaluate their liquidity. These ratios help them to measure their financial health. The three most important ratios include the current ratio, quick ratio, and cash ratio.

Let us look at a few interesting facts about the above ratios-

  • The current ratio is believed to be the simplest and less stringent.
  • Quick Ratio is also referred to as the acid-test ratio.
  • The cash ratio is believed to be the most exacting of the liquidity ratios. More than the other two ratios, it assesses the business’ or individual’s ability to stay solvent in the case of an emergency.

 

Liquidity Management

At any point in time, and especially in turbulent times, a Company may be asked to demonstrate its ability to remain viable and liquid. This is where liquidity management comes into the picture.

Liquidity management describes a company’s ability to meet financial obligations via cash flow, funding activities, and capital management. It is impacted by revenue and cost generating activities, capital and dividend plans, and tax strategies- making it a challenging concept. Liquidity management is strongly associated to broader market, credit and general business risks.

So how is liquidity managed?

For starters, monitoring the liquidity ratio is key to keep a regular grasp of the company’s liquidity risk. To do so, most liquid assets are compared with short term liabilities or near-term debt obligations.

Other techniques comprise-

  • Receivables management– the stringent methodology to make sure that clients and customers maintain payments in a timely and orderly fashion.
  • Netting portfolio management techniques- which allows the company to consolidate debt obligations. Herein, the company nets third-party invoices. It is usually applied when the company has several outstanding invoices from the same vendor and agree on terms by which the total outstanding amount will be paid on a certain date. By practising this approach, a single payment suffices rather than a number of instances to unsettle cash reserves.

 

Understanding Liquidity Glut & Liquidity Trap

While walking through the concept of liquidity, understanding liquidity glut & liquidity trap is essential.

Liquidity Glut—when savings exceeds the desired investment

As understood, high liquidity means a lot of capital. But what happens when there is too much capital and too few investments? A liquidity glut. This is a situation wherein savings exceeds the desired investment. Often a liquidity glut may lead to inflation. Cheap money pursues lesser profitable investments, and prices of those assets increases.

Liquidity Trap- monetary policy becomes ineffective

This occurs when the Government’s monetary policy does not create more capital; for example, post a recession. In this situation, interest rates are extremely low, whereas savings are high, making monetary policy ineffective. Consumers ideally prefer to save rather than invest in higher-yielding bonds or other investments. Raising interest rates is one of the most effective ways to get out of a liquidity trap, the other being increasing government spending, which may in turn aid unemployment too.

We use cookies to ensure that we give you the best experience on our website. If you continue to use this site we will assume that you are happy with it. OK