What is financial liquidity? | Bank rate | Jobs Vox

Financial liquidity is the ease with which an asset can be converted into cash. In contrast, an asset that is considered illiquid cannot easily be converted into cash or is difficult to trade.

Why is liquidity important?

For businesses, liquidity is an important part of corporate risk assessment and indicates to investors how much money is available to cover short-term debt and other obligations. For example, a company needs liquid assets to pay interest on its debt and pay dividends to shareholders. Additionally, liquid assets are often needed to grow a company. Salaries, rent, and other operating expenses also typically require liquid assets.

On a personal finance level, you need liquid assets to fund an unfunded down payment. And, some real estate transactions, such as buying a condominium or condo building, require a certain amount of liquid assets to make sure you have the money to pay maintenance or homeowner association fees. Beyond that, you’ll need some easily accessible cash to cover bills, debts, and emergencies.

Examples of liquid assets

Cash is the most liquid asset, followed by cash equivalents such as treasury bills, treasury notes and certificates of deposit (CDs) with maturities of three months or less. A CD that is longer than three months can still be considered liquid if you are willing to pay the penalty for getting the money before the maturity date. Other liquid assets are checking accounts, savings accounts, money market accounts, and money management accounts.

What about your brokerage account? Well, marketable securities like stocks, bonds, ETFs and mutual funds are considered liquid because they can be sold or traded quickly. That said, securities are considered less liquid than cash, as it sometimes takes three to five days for trades to settle and the proceeds to hit your account.

Examples of small liquid assets

Less liquid assets usually have higher prices and longer time to sell. Houses, land and other real estate fall into this asset category. You can turn these investments into cash, but the process can take months or years and usually involves a number of other costs, such as realtor commissions and closing costs.

Other examples of illegal assets include fine art, collectibles, jewelry, personal company interests, and cars. It is not legal to use goods and materials for business purposes. Think of it this way: if you have to find a buyer and the item is unique and/or high priced, it will probably be less liquid.

That means, assets can be exchanged in a liquid manner. For example, crypto is considered liquid, but it is less liquid than cash because of the time it takes to convert cryptocurrency into cash. Same with containers. Bonds are less liquid than stocks, but more liquid than real estate. Think of liquidity as a scale rather than an absolute category.

How to measure cash flow

You can measure liquidity using different ratios. Investors and creditors use these ratios to determine whether and to what extent a company can cover its short-term obligations. Lenders can use these ratios to help determine loan eligibility. Here are the most common ones:

Current Ratio: Also known as the capital ratio, the current ratio is calculated by dividing current assets by current liabilities – two figures found on a company’s balance sheet. If the ratio is one, the company can cover its debts properly. Anything under one means that the company’s liabilities exceed its assets. Here’s the formula:

Current ratio = current assets / current liabilities

Quick Ratio: The quick ratio, sometimes called the acid-test ratio, is similar to the current ratio but excludes less liquid assets such as inventory and prepaid expenses. You can use this formula to get a more accurate measure of a company’s ability to pay its obligations. For example, a quick ratio of less than one indicates a higher risk of bankruptcy. If the company’s creditors all call their loans, there is not enough money to cover them. A quick ratio is a more conservative take than the current ratio.

Quick ratio = (cash + accounts + marketable securities) / current liabilities

Cash ratio: The most conservative of these three ratios, the cash ratio is calculated by dividing cash by current liabilities. Companies with high profits and cash tied up in long-term investments will have a lower ratio than a company with more cash and cash equivalents.

Cash Ratio = Cash / Current Liabilities

Liquidity risk

Liquidity risk occurs when a company or individual cannot buy or sell an investment in exchange for cash quickly enough to pay off its debt. For example, if a company needs to make a large purchase within 30 days, but most of its assets are tied up in long-term investments, the company has liquidity risk.

For an individual, this means owning a home but not having enough money to cover utility bills and student loan payments. If your only assets are your house and your car — both illegal assets — you risk a deduction.

Financial liquidity and solvency

Financial solvency refers to the ability of a business to meet its short-term obligations, while solvency refers to the ability of a business to pay its long-term debts and obligations. A company may be liquid, but it has less liquidity. An example is a company that has large inventory, such as a factory, and many sales and incoming orders, but no cash on hand. This can happen if a business uses profits to buy more raw materials or real estate.

Benefits of financial liquidity

Some of the benefits of cash and cash equivalents include:

• Less risk of bankruptcy.
• Greater access to credit.
• Low variability.
• Liquid assets generally have a lower yield and therefore less tax relative to the interest earned.
• More flexibility.
• Get discounts for paying in cash.

Disadvantages of financial efficiency

While liquidity is important, there are many downsides to holding additional cash assets, including:

• Low interest rates.
• Loss of purchasing power over time as inflation returns.
• Possible inflation.

at last

Analyzing liquidity helps you understand the financial health of a business. While not the only number you need, liquidity ratios give you an indication of a company’s ability to cover short-term liabilities and expenses.