One of the most common words that we hear in both our discussions and readings about picking investments is the word ‘liquidity’. In fact, investors often say that two of the most important factors that they use to pick their investments are liquidity and price. Since you no doubt understand the value of looking at the prices of various investments, we figured that it might be good to brush you up a little bit on the idea of liquidity. While many of us understand liquidity in a general sense, we may not completely understand the number of ways that we can use liquidity as a measure of a company’s economic performance. We have no doubt that improving your understanding of liquidity will be helpful in your investment research! So, in order to help you better break down the concept of liquidity, we have created a quick guide for you to reference.
First, we can start with the basics. Liquidity is defined as “the degree to which an asset or security can be quickly bought or sold in the market without affecting the asset’s price.” Other investors simplify this idea by thinking of liquidity as “the ease of converting assets into cash.” Essentially when thinking about liquidity, investors ask: how easy is it to buy or sell an investment if we need to?
This measure can help investors choose which asset classes to invest in, as some assets are more “liquid” than others. For example, say that you recently had a minor emergency and you needed some cash to help you pay off a debt. If you needed to take your money out of some investments to meet this quick demand for cash, it would be much easier to do so if your assets were more liquid. Selling your stocks might be simpler than selling fixed assets, like a car, for example. Therefore, we would say that stocks are more liquid than fixed asset investments. For investors who might need to pay off debts more frequently, then, considering the liquidity of different investments can be a big factor in which investments they choose.
On the other hand, we can also use liquidity to differentiate between the companies that we are investing in. A business’s liquidity is important because it can directly affect the value of our investments. For example, we can judge a company’s financial health by looking at its assets. If a company has $5 million in assets and only $500,000 are liquid – meaning their other assets are likely fixed assets which may depreciate over time – we would probably want to look further into the company’s financial stability. This would be due to the fact that most of the company’s assets are not liquid and cannot be used to pay off debts as easily. But, if a company had $5 million in assets and $4 million of those assets were liquid, we might be more likely to trust that company, expecting that they could more easily and quickly handle any future financial trouble. Essentially, this measure of liquidity gives us a sense of what kind of “safety net” we can expect a company to have in terms of paying off future debts.
In your research of a company’s liquidity, you might also come across the terms ‘current assets’ and ‘current liabilities’. In accounting, ‘current assets,’ are any assets that can be converted into cash within the next year. These are typically defined as “liquid” – although some might certainly be more liquid than others. ‘Current liabilities’ are usually the debts that will need to be paid within the next year. When comparing these two numbers, investors usually hope that current assets are more valuable than current liabilities. This is a key indicator of a company’s financial health and the ability to pay off debts in the short term.
All things considered, these measures of liquidity can help investors both choose the kinds of assets to invest in and differentiate between various companies’ stocks that they may be considering. While liquidity is not the only factor to consider when making your investing decisions, it can definitely help to have another measure of financial stability to throw into your investment analysis!