Liquidity plays an important role in many contexts and is of central importance for companies. Here we give you an overview of what liquidity means in concrete terms and use examples to show you what it means in different contexts.
Liquidity: Definition
Liquidity is the ease with which an asset or collateral can be converted into cash without losing its monetary value. Assets and collateral can therefore be divided into different liquidity levels depending on how efficiently they can be liquidated.
Examples for liquidity assets
Cash is the most "liquid" form of liquidity. In addition to notes and coins, it also includes account balances and cheques, as well as cash in foreign currencies. Other forms of liquidity assets that can be converted into cash very quickly due to their low risk and short maturity are treasury bills and treasury notes.
Securities that can be sold in the short term, e.g. shares, can also be quickly converted into liquidity by selling them. In contrast, assets such as production machinery or warehouses are more difficult or less quick to convert into liquidity and often incur losses when sold.
Liquidity ratio as a measurement for liquid assets
There are various formulas for measuring liquidity that can be used to assess different aspects of the liquid situation.
Current ratio
The current ratio compares current assets with current liabilities:
Current ratio = Current assets / Current liabilities
This ratio indicates how well a company can cover its short-term liabilities with its short- term funds. Short-term funds include: Cash, accounts receivables and inventories. The higher the current ratio, the more funds the company has available to cover its expenses.
Quick ratio
The quick ratio is a variation of the current ratio. It indicates how well the company can meet its short-term liabilities if it uses only its most liquid funds, i.e. only cash and cash equivalents. Inventories are therefore not taken into account in the calculation.
Quick ratio = (Cash & cash equivalents + marketable securities + accounts receivables) / Current liabilities
Marketable securities are, for example, shares or other securities that can be sold quickly.
Liquidity examples in various contexts
Liquidity occurs in many contexts and plays an important role not only in the financial management of a company. Therefore, we have compiled some examples of where liquidity often appears and what it means in the respective context.
Liquidity in accounting
When we talk about liquidity in accounting, we mean how easy it is for a company to meet its financial obligations. If a company has a high level of liquidity, it can pay its invoices on time and in the correct amount, and the risk that it will run into payment difficulties is low.
If, on the other hand, the company has low liquidity, it may have problems paying its bills on time. Such a liquidity bottleneck is feared by financial managers because it leads to insolvency if it persists for a long time.
Liquidity in stocks & investments
When trading on the stock exchange, the liquidity of shares or other stock exchange products describes how quickly they can be sold. If a share has a high liquidity, it can be sold quickly without the sale having a major impact on the share price.
Shares with low liquidity are more difficult to sell and can become a minus transaction for the seller because he cannot sell them at the desired time.
Liquidity risk
In this context, the liquidity risk also plays an important role. The higher the risk, the more difficult it is to sell an exchange product at the desired time. This is especially the case with assets for which penalties are due if they are sold prematurely, e.g. certificates of deposit (CDs).
Liquidity in banking
Just as for companies, liquidity is also of central importance for banks. A bank's liquidity indicates how much cash it has to finance its day-to-day business.
In addition to the cash and accounts they manage for their customers, banks' liquid assets also include central bank reserves and investments in safe investment products, e.g. government bonds.
Liquidity is therefore different from a bank's capital. The latter shows how many funds are available to compensate for losses. Capital is therefore the difference between assets and liabilities.
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