Key takeaways

• Liquidity measures how quickly and easily an asset can be converted into cash without significantly affecting its current market value.
• Cash and cash alternatives are the most liquid assets, while stocks and bonds vary in liquidity. Tangible assets, including real estate, are considered illiquid assets.
• Market liquidity measures how easily assets can be bought and sold at a stable price; accounting liquidity assesses a company's ability to pay short-term debts.

Liquidity is how quickly and easily an asset can be converted into cash without significantly affecting its market price. The two types of liquidity, market and accounting liquidity, can play an important role in shaping your investment decisions and helping you secure personal or business loans.

What is liquidity?

Liquidity represents how quickly and easily you can convert a financial asset, such as a stock or bond, into cash while preserving its current market value. The easier and faster you can convert an asset into cash without impacting its market price, the more liquid the asset is.

An asset’s liquidity can change as market conditions shift. Assets that are easy to sell under normal conditions can become more difficult to sell without affecting their value during market stress.

Why is liquidity important?

Understanding the liquidity of specific assets can help shape your investment decisions. Selecting a mix of both liquid and illiquid assets can help you invest for specific goals while keeping a separate liquid fund for expenses and financial emergencies.

A business’s liquidity may also affect its ability to secure financing. Lenders and investors often analyze a company’s liquidity ratio before approving any type of business loan or making an investment. The liquidity ratio determines the company’s ability to convert its assets into cash in comparison to its debt obligations. While what’s considered an acceptable liquidity ratio varies greatly, most lenders and investors are looking for companies with a ratio of at least one.

Read more: How to start investing: A beginner’s guide to investment basics

Examples of liquid assets

Several common types of liquid assets include:

• Cash is considered the most liquid of all assets. With cash, including savings and checking accounts, no conversion is necessary as these funds are already fully available to you. Empower data shows that investors in their 20s tend to keep around 38.7% of their assets in cash, while those in their 30s lean closer to 28%.
• Cash alternative investments such as CDs, treasury bills, and money market accounts are considered liquid assets, though their liquidities are tied to their investment terms. For example, CDs are often held for a specific term ranging from a month to several years. Though they can be converted to cash rather quickly, you may incur penalties for cashing them in early.
• Stocks and bonds are also considered liquid assets, though their level of liquidity can vary greatly. Large-cap stocks are known for their high trading volume, tight bid-ask spread, and fast trade options. This combination makes them highly liquid investments.

Tangible assets, such as real estate, art, collectibles, jewelry, and equipment, are generally considered illiquid. These assets are more difficult to convert into cash because it can take longer to secure a buyer. If you need to sell them quickly, you may do so at a loss.

Read more: What are liquid assets?

Types of liquidity: Market vs. accounting liquidity

There are two primary ways to measure liquidity: market liquidity and accounting liquidity. Both methods of measuring liquidity are effective, but they serve very different purposes. Whether you’re an investor or business owner, it’s important to understand the difference between market and accounting liquidity.

Market liquidity

Market liquidity measures how easily assets within a given market can be bought and sold at a stable price. Highly liquid markets allow assets to be bought and sold quickly and without causing a significant drop in value. Low-liquid markets are the exact opposite. In these markets, it can be difficult to sell and buy assets or to do so without incurring a significant drop in the price of the asset.

If you’re looking for investment options that you can easily convert into cash, it may be ideal to look for those in high-liquid markets.

Accounting liquidity

Accounting liquidity measures a company’s ability to pay off its short-term debts. This measurement compares the company’s current assets against its current liabilities to determine a liquidity ratio. This ratio often serves as a good indicator of the overall financial health of a company.

Naturally, companies use this measurement to assess their own financial health. However, investors and lenders also use accounting liquidity when making investment decisions or loan approvals. While there are no specific standards for identifying a good accounting liquidity ratio, investors should look for companies that have a minimum ratio of one.

How to measure liquidity

There are several techniques you can use to measure the liquidity of an organization. Below is a look at the four most common methods: the current ratio, quick ratio, acid-test ratio, and cash ratio.

Current ratio

The current ratio technique for measuring liquidity provides a quick overview of the company’s overall financial health. The formula is quite simple and uses data right from the company’s financial statements. This allows investors with limited company data to still measure the liquidity ratio prior to investing.

current liquid assets / current liabilities = current ratio

In this formula, current liquid assets and current liabilities are defined as those that can be turned into cash or are owed within one-year period.

Quick ratio

The quick ratio method is similar to the current ratio, except it only includes the most liquid assets, such as cash and cash alternatives. This measurement evaluates how financially able the company is to pay off its current debt obligations.

quick assets / current liabilities = quick ratio

Quick assets in this formula include cash, cash alternatives, marketable securities, stocks, bonds and net account receivables.

Acid-test ratio

The acid-test ratio is similar to the quick ratio, but it removes inventories and prepaid costs from the equation.

(current assets – inventories – prepaid costs) / current liabilities = acid-test ratio

While the acid-test ratio serves many purposes, investors may want to use a more in-depth assessment method to obtain a clear view of the company’s financial health.

Cash ratio

The cash ratio can provide a more accurate view of the company’s financial health and its ability to meet its short-term debt obligations. It shows the company’s ability to repay its debt in emergency situations.

(cash + cash alternatives) / current liabilities = cash ratio

This formula removes all inventories, accounts receivable, and all liquid assets (except for cash and cash equivalents).

Are stocks liquid assets?

The liquidity of stocks varies greatly based on three primary factors: their trading volume, bid-ask spread, and the efficiency of their respective markets.

When comparing stock investment options, understanding these three factors can help you build a portfolio that reflects your desired level of liquidity.

Trading volume

Traditionally, stocks with a high trading volume are the most liquid options. Since so many of these stocks are bought and sold throughout the day, it’s usually easy to sell them and convert them to cash if necessary.

Bid-ask spread

A stock’s bid-ask spread represents the difference between the highest price a buyer is willing to purchase the stock for and the lowest price the seller is willing to sell it. A tighter bid-ask spread typically indicates higher liquidity, which means you likely can sell the stock quickly without a significant drop in its value. On the other hand, a wider spread often signifies less liquidity, which means you might realize a loss through a quick sale.

Trade process efficiency

The ability to sell a stock quickly also depends on the efficiency of the trading process in the market where you purchase the stock. The more efficient this trading process is, the more liquid the stock is. However, markets with complex and time-consuming trading processes can diminish a stock's liquidity.

Our take

Whether you’re a business owner or an investor, it’s crucial to understand the meaning of liquidity and how it can help you make sound investment decisions. Choosing highly liquid assets can allow you to make investments while maintaining peace of mind that you can quickly convert these assets into cash if necessary.