The concept of liquidity is often found in professional literature, but novice investors rarely pay attention to it. And in vain. After all, the amount of risk and profitability depend on the liquidity of assets. And the quality of the investment portfolio determines investment tactics and strategy, not to mention financial stability. Let's take a closer look at this important economic category.
Economic essence
What is liquidity in simple words? Liquidity is the ability to quickly turn into money without large financial losses. The term liquidity comes from the Latin liquidus - liquid, current, that is, easily converted into money.
The above definition sets the main parameters:
- transformation time;
- the amount of financial costs associated with the transformation.
How is liquidity measured?
The number of days required to sell an asset at the average market price:
- So, you can sell or redeem a high-yield security within a few minutes;
- and the financial liquidity of investments in the construction of a cottage community is measured in years.
The most indicative in this sense is the structure of the assets of any manufacturing or trading enterprise. Liquidity:
- Absolute. Assets do not require transformation and are ready-made means of payment (cash and cash equivalents).
- Urgent (up to 7 days). Short-term investments (for example, in government bonds and bills).
- High (up to 30 days). Goods shipped, short-term accounts receivable.
- Medium (up to 90 days). Work in progress, inventories in warehouses (raw materials, materials and finished products).
- Low (up to 360 days). Long-term investments, accounts receivable.
- Illiquid assets. Fixed assets (machinery, equipment, buildings, structures) and intangible assets.
Keep in mind that the above classification is quite arbitrary, since in each group it is possible to identify specific assets that have varying degrees of turnover depending on the specifics of the activity. Thus, the “life” of receivables may vary. “Long” debt becomes low-liquidity or even illiquid.
With the urgent transformation of any instruments into cash, financial losses are inevitable, which include:
- discount to the market price of an asset provided by the buyer for the purpose of prompt sale;
- additional selling costs (taxes, fees, duties, commissions, etc.).
The following classification of financial losses has been adopted: low (up to 5%); average (up to 10%); high (up to 20%); very high (over 20%).
Obviously, financial losses and the speed of transformation are inversely related.
Why is she so important?
Liquidity is the second most important (after profitability) characteristic of any asset, including investment.
For an investor, especially one operating in the financial market, assessing the quality of an investment portfolio becomes more important than for a large manufacturing or trading enterprise. Causes:
- An individual investor is one by definition. Its ability to attract alternative sources of capital (and thus reduce risks) is limited.
- The average investor, as a rule, does not have a large “safety cushion” behind him in the form of fixed assets: buildings, structures, machinery and equipment.
- In pursuit of profitability, he tends to invest in riskier assets.
Thus, for a portfolio investor, high liquidity means:
- flexibility of investment strategy and tactics (the ability to quickly withdraw funds from ineffective projects and reinvest them);
- speed of turnover, and therefore profitability (the faster you earn money on an investment instrument, the higher the interest rate of effective profitability);
- personal financial stability.
Rule 1. All things being equal, invest in assets with a high degree of liquidity. This will give you freedom of maneuver in the process of managing your investment portfolio.
Rule 2. Profitability and liquidity are interconnected. Investments in low-liquid assets should generate greater investment income.
How to assess the liquidity of an asset
The liquidity of an asset represents the market capacity in which it can be sold or bought.
Market liquidity is determined by:
- Number of transactions.
- The spread (difference) between the maximum stated purchase price (demand) and the minimum stated sale price (offer).
Rule 3. The larger the volume of transactions and the narrower the spread, the more liquid the market.
Thus, individual transactions will not have a significant impact on the market as a whole. This means that if you have an asset with average market parameters, you can sell it at any time.
By analogy with the general rules:
- the instant liquidity of a security on the stock market is determined by the number of quoted orders (the author indicates the price and volume, giving other players the opportunity to buy or sell a financial instrument at any time);
- the trading liquidity of a security is determined by the number of market orders (the author indicates only the volume, the transaction is concluded automatically at the best quotation price).
You can always find such information on stock exchange portals, financial and brokerage sites.
Increased price volatility and decreased trading volume indicate investor anxiety and are the first symptoms of increased investment risks. If the situation continues for more than the first week, the liquidity of securities, and with it the profitability, will inevitably begin to fall.
Obviously, it is possible to assess the liquidity of assets in this way only on the exchange market, where securities are traded in an open financial market and free competition.
The rules for trading in the over-the-counter market are established by the counterparties themselves, and the process of concluding a transaction becomes several times more complicated (searching for clients, attracting intermediaries and guarantors, confirming the legal status of the transaction, etc.). As a result, the degree of liquidity of assets in the over-the-counter market is an order of magnitude lower. Moreover, it is difficult to accurately predict and calculate it.
- Study the one-room apartment market segment: the number of transactions during the period, the average price per square meter, the average price of the property, the price range. You can easily obtain such information from real estate market reviews, analytical studies, and agency websites. From the analysis you will learn that the market for economy class apartments in Moscow is considered a well-liquid segment of the real estate market.
- Determine the required level of profitability from the sale.
- Predict the time required to find a buyer.
- Calculate the time required for the entire range of legal and administrative procedures related to the sale (about 1 month).
- Assess the associated financial and tax costs.
Thus, the sales operational cycle alone (searching for a buyer, completing a transaction and receiving funds) will take you 2–3 months. And if you are counting on excess income, the process may take up to six months. That is, a “good” asset by the standards of the real estate market is quickly turning into a low-liquid asset.
What is project liquidity
For the purposes of this article, we will define it as the period of time that has passed from the moment of the first investment until the potential sale of the asset at a price that compensates for the investment, taking into account the time factor (discounting). If you invest money in a venture project today, this investment asset will not become liquid until you are able to exit it with a profit. The event is probabilistic in nature, which means that in the early stages such investments are completely illiquid.
How to assess the liquidity of an investment portfolio
How to value a specific asset is relatively clear. But what to do if we are talking about a comprehensive assessment of the quality of the portfolio of an individual investor or an investment company? In commercial enterprises, special coefficients are used for this:
- Absolute liquidity = (Cash and cash equivalents + Short-term investments) / Current liabilities. Standard: 0.2.
- Quick (quick) liquidity = (Current assets - Inventories) / Current liabilities. Standard: 1.
- Current liquidity = Current assets / Current liabilities. Standard: 2.
What is enterprise liquidity? The higher the ratios, the faster the company will be able to turn part of its assets into cash to avoid problems. Moreover, the value of the last coefficient already borders on the assessment of the state of financial stability.
What should a simple investor do? Go the same route.
- Assess the level of liquidity of each specific asset included in your investment portfolio.
- Group your assets.
- Calculate the share of each group in the total portfolio.
Instead of a conclusion
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Real estate.
If we evaluate all financial instruments, real estate is a low-liquid instrument. But if we consider only one, then again there is a division into low- and high-liquidity.
Let’s say that luxury apartments and country houses with high prices are low-liquid real estate. It takes a significant amount of time (several months) to sell it at a fair market price. And even then, in the end, you still have to reduce the price to the buyer.
And if you take economy-class housing, and even in a good location in the city (somewhere in the center, or in a normal area), then you can consider it as highly liquid real estate due to the fact that there is always demand for it and it can be easily sold literally in a couple of weeks, at most 1-2 months.
Why is liquidity so important?
The concept of liquidity is important for investors whose goal is to make a profit on their investment. And in the event of any negative circumstances in the financial market, they should be able to quickly get rid of unnecessary assets at reasonable prices. And transfer the money received to another most promising (and more profitable) financial instrument.
Therefore, when investing money, an investor always tries to choose highly liquid instruments.
Let’s say, if we consider the real estate market, then with a downward trend in prices, you can most quickly get rid of inexpensive real estate properties. Those. if you choose between ordinary Khrushchev apartments and premium housing, the investor will choose the first, due to their high liquidity.
The same is true about the stock market. In the event of a possible stock market crash (which happens periodically), the investor must quickly and with minimal losses get rid of the asset that is falling in price. And if in his portfolio there are only low-liquid shares for which there is no buyer, then all he can do is watch how the value of the shares he purchased decreases. And count the losses in your head.
The concept of liquidity in economic science implies the mobility of assets and funds, which can ensure the possibility of uninterrupted payment of obligations.
Liquidity is practically a key characteristic in many economic studies and processes. It can be attributed both to a specific enterprise, industry, and to the country as a whole and even to the global market.
Within the framework of this article, the concept of liquidity in relation to money will be examined in more detail.
Liquidity of money is a basic concept in accounting, financial analysis, management, and investment analysis. Since it represents the ability of assets to transform from one form to another without significant financial loss.
The essence of the concept
Liquidity of money is understood as the convenience and speed of converting available assets (property) into cash, which is used for subsequent purchases. Complete absolute liquidity of money can only be attributed to cash. And then other types of money become less liquid: savings on a card, deposit account in a bank, etc. Converting the latter into cash involves certain financial losses, so they are considered less liquid.
Properties of any asset in accordance with the concept of liquidity:
- the ability to use this asset as a real means of payment;
- the ability of an asset to retain its original value.
Cash is the most direct means of payment, which is why it is said to have absolute liquidity. Demand deposits have slightly less liquidity. Further, the level of liquidity is lower for time and savings deposits and government bonds.
The liquidity factor has a huge impact on the decisions made by firms and companies. Under equal conditions, preference is given, as a rule, to absolutely liquid cash or demand deposits.
It can be said quite accurately that the difference between money and its characteristic feature in economic science is considered to be the fact that money has liquidity. Money refers to liquid, that is, easily realizable property. Currently, having liquid assets (money) means having great opportunities, that is, ultimately, great wealth. The wealth of a particular individual will depend on the form in which property benefits belong to him at a given moment in time.
Let's give an elementary example. A man wants to eat at a restaurant, but he only has a bank card with him, which contains 1000 rubles, and does not have cash. At the entrance of the restaurant it is written: “We do not accept cards for payment.” Can this person be called rich at this point in time? No, because if there were 1000 rubles in the card account. less, and in your pocket for 1000 rubles. more cash, then the person would be richer than in this situation.
Flaw
Despite the fact that money has absolute (perfect) liquidity, there is also a disadvantage of this fact: the owner of the money has to lose the income that he could have received by using an asset with less liquidity. This means that if cash is deposited in a bank account, it will bring a stable income to its owner. However, such income will be lost if the money is kept “at home on a shelf.” There are better ways to invest your cash, such as stocks, bonds, dividends, etc.
Monetary aggregates by degree of liquidity
In accordance with the liquidity criterion, modern money can be divided into the following main groups in the form of monetary aggregates (indicators of the money supply determined by its level of liquidity):
- M0 - money on hand, demand deposits.
- M1 - aggregate M0, savings deposits, small time deposits.
- M2 - unit M1, large time deposits.
- M3 - M2 aggregate, savings bonds, government and commercial bills.
Conclusion
The liquidity of cash lies in its ability to be a means of payment. This fact influences the decisions of manufacturers. For example, organizations and firms give preference to cash or deposits in payments.
What is liquidity? This question arises among people who are far from economic realities and among experienced businessmen. Liquidity is the ability to quickly turn assets into their cash equivalent at good prices. There are high- and low-liquid assets, as well as illiquid assets. The concept of liquidity can be applied to any firms, securities, real estate, vehicles and various property owned by a business or individual. Usually, the money that circulates in a given economic system has the highest liquidity.
Liquidity ratio
The liquidity of any organization and company is calculated using several financial indicators, one of which – the liquidity ratio – is calculated using special formulas. Using this ratio, you can compare the value of current assets, which have different degrees of liquidity, with the amount of current liabilities. There are coefficients:
- overall liquidity or coverage, which shows how capable the enterprise is of meeting its short-term obligations;
- current or quick liquidity, which shows what part of the company’s obligations can be repaid using cash and financial investments;
- absolute liquidity, allowing to determine short-term liabilities, the debt on which the company can repay urgently.
Current liquidity
To know how much of a firm's or organization's current liabilities can be paid with existing cash or cash equivalents, investments, and accounts receivable, it is necessary to know what quick or current liquidity is. The quick liquidity ratio is calculated using a special formula. The indicator of this type of liquidity indicates how solvent an organization or firm is, how quickly it can pay off current obligations, paying debtors on time. Typically, a quick ratio of 0.6 is considered acceptable.
Balance sheet liquidity
The financial indicator - balance sheet liquidity - shows the extent to which the company's liabilities are covered by assets that can be converted into money within a time frame corresponding to the maturity of the liabilities. The solvency of any company and enterprise depends on this indicator. To find out how favorable the financial position of an enterprise is, you need to know how much the value of current assets exceeds short-term liabilities. The higher this value, the better off the company is in terms of liquidity. Determining balance sheet liquidity is of particular importance during liquidation in case of bankruptcy of an enterprise or company.
Liquidity analysis
To analyze the liquidity of the balance sheet of a company or organization of any form of ownership, assets are grouped by degree of liquidity - from the fastest to assets with slow liquidity. A correct analysis of asset liquidity is carried out in the following order:
- the most liquid assets;
- quickly implemented;
- slow to implement;
- hard to sell assets.
As for liabilities, the most urgent liabilities are analyzed first, then short-term liabilities, long-term liabilities and finally permanent liabilities.
Absolute liquidity
If you need to calculate the reliability of a company or quickly liquidate it, you need to know its financial indicators. One of them, absolute liquidity, is a ratio showing how much of short-term debt can be repaid immediately. The absolute liquidity ratio or Cashratio shows how much a company or enterprise is able to repay short-term debt immediately. This indicator is calculated as the ratio of current assets that can be immediately sold to the debtor's current liabilities.
Liquidity indicators
Liquidity is the most important indicator of the efficiency and reliability of an enterprise. It shows how creditworthy the company is. To know exactly how promising a particular company is, it is necessary to analyze their work. When analyzing the activities of any company, it is necessary to take into account balance sheet liquidity indicators. The main coefficients are:
- absolute liquidity;
- critical evaluation;
- maneuverability of functioning capital;
- current liquidity;
- security of own funds.
Asset liquidity
Company assets that can be quickly and profitably converted into money are called liquid. The most highly liquid asset is the funds that the company has in cash, accounts, and deposits. Good liquidity of assets in securities that can be sold profitably on the stock exchange at any time. The least liquid are considered to be inventories of raw materials, materials, and the value of work in progress. The accounting analysis of balance sheet liquidity is based on the principle of increasing liquidity; the most important when preparing the balance sheet are three coefficients:
- absolute liquidity;
- quick liquidity;
- current liquidity.
Bank liquidity
Any organization can be considered from a liquidity point of view, including financial ones. Such a concept as a bank's liquidity - its ability to quickly fulfill obligations to depositors, investors, creditors - is very important when choosing a bank. The obligations of a financial organization can be real, potential or contingent. Bank liquidity factors are external and internal. Internal factors are:
- bank management and its image;
- quality of funds raised;
- quality of bank assets;
- conjugation of assets and liabilities.
External liquidity factors are;
- the state of the economy in the country;
- development of the securities market;
- effectiveness of Bank of Russia supervision;
- refinancing system.
Liquidity of the enterprise
The liquidity of an enterprise is the ability to pay off its debts quickly and profitably. The degree of liquidity is determined by the ratio of balance sheet assets and liabilities and determines the stability of the enterprise. A company's liquid funds are all those assets that can be converted into money and used to pay off debts. This is money on hand, in accounts and deposits, securities that are quoted on the stock exchange, working capital that can be quickly sold.
There is general (current) and urgent liquidity of the enterprise. Total is the ratio of the sum of current assets and liabilities at the beginning and end of the year. The analysis of an enterprise's liquidity is determined by ratios. If the current liquidity ratio is below 1, this means that the company does not have stability. The normal indicator is over 1.5.
Market liquidity
Liquidity is an important indicator of any market. To make transactions on the stock market or the so popular Forex market, you need to know which exchange instruments can be quickly bought and sold just as quickly. Market liquidity is the opportunity to make a profitable deal with stocks, futures, and currency pairs without losing price or time. In other words, a market participant will receive any asset at the best market price as quickly as possible. Money has the highest liquidity - it can be instantly exchanged for goods. Real estate has low liquidity.
Liquidity of securities
The liquidity of securities is the ability to turn them into money quickly and profitably, and this opportunity is constant. It is this characteristic that is taken as the basis for understanding how effective certain securities are. High liquidity will allow the investor to instantly receive cash for securities.
The main characteristic of the liquidity of securities is the spread - the difference between sale and purchase prices. The smaller the spread, the higher the liquidity. Liquidity is influenced by the investment attractiveness of a particular issuer's securities. It can be calculated if the performance indicators of the enterprise and the assessment of its securities by the market are known.
Liquidity of money
Money has the highest, one might say, perfect liquidity. The liquidity of money means that it can be used to obtain goods or services that are needed at any time. Money is a means of payment in any country in the world. They are most protected from fluctuations in their value. Universality as a means of payment, that is, liquidity, makes money the most sought-after asset. Cash has the greatest liquidity, followed by funds on the current deposit. In last place are securities that still need to be sold on the stock market.
Do you know how easy it is to cash out your own funds? It all depends on the form in which they are stored. Liquidity of money is a basic concept in accounting, finance and investing. It reflects the ability of assets to transform from one form to another. A desirable outcome for any company is that this operation occurs quickly and without significant financial losses. Therefore, the liquidity of which is considered absolute is still so important. We will begin our article with the definition of this concept. Then we move on to consider the types of enterprise performance indicators and the role of banks in maintaining a certain level of liquidity.
Definition of the concept
Liquidity of money in accounting characterizes the ease of converting the assets at the disposal of an enterprise into cash. The latter can be used to buy anything at any time. money concerns only cash. Savings in a current card account cannot be used to buy vegetables from a farmer at the market. Money on deposit is even less liquid. This is because they cannot be obtained instantly. In addition, early termination of an agreement with a bank is often fraught with additional financial losses.
Money, liquidity and asset types
The funds available to the enterprise take the following forms:
- Cash.
- Funds in current accounts.
- Deposits.
- Savings Loan Bonds.
- Other securities and derivative banking instruments.
- Goods.
- Shares of closed joint stock companies.
- Various collectibles.
- Real estate.
Please note that this list is arranged in descending order of their liquidity. Therefore, you need to understand that the presence of real estate is not a guarantee of protection against insolvency in times of crisis, since it may take weeks, if not years, to sell it. Making a decision to invest money in any type of asset should be based on its level of liquidity. However, some valuables do not need to be sold to get quick cash. Money can be borrowed from a bank using, for example, real estate as collateral. However, such an operation is associated with financial and time costs. Therefore, cash liquidity is the benchmark for all other types of assets.
In accounting
Liquidity is a measure of a borrower's ability to pay its debts when due. It is often characterized by a coefficient or percentage. Liquidity refers to the ability of an enterprise to pay its short-term obligations. The easiest way to do this is with cash, as it is easily converted into all other assets.
Liquidity calculation
There are several ways to calculate this indicator on the balance sheet of an enterprise. They include the following:
- Current ratio. It is the easiest to calculate. This coefficient is equal to the result of dividing all by the same liabilities. It should be approximately equal to one. However, you need to keep in mind that some assets are difficult to sell for full value in a hurry.
- Quick ratio. To calculate it, inventories and receivables are subtracted from current assets.
- Operating cash flow ratio. The liquidity of money is considered absolute. This indicator is calculated by dividing available cash by
Using odds
It is appropriate to use separate indicators for different industries and legal systems. For example, businesses in developing countries need greater levels of liquidity. This is due to a high level of uncertainty and slow returns on investment. For an enterprise with a stable cash flow, the quick ratio is lower than for an Internet startup.
Market liquidity
This concept is key not only in accounting, but also in banking. Insufficient liquidity is often the cause of bankruptcy. However, too much cash can also lead to it. The lower the liquidity of assets, the greater the income from them. Cash does not bring it at all, and the interest on money in a current account is usually more than modest. Therefore, enterprises and banks strive to reduce the number of highly liquid assets to the required level. This concept has a slightly different meaning in relation to stock exchanges. A market is considered liquid if securities in it can be sold quickly and without loss in their prices.
conclusions
Liquidity is an important concept for both large corporations and individuals. A person can be rich by counting all the assets he owns, but fail to pay off his short-term liabilities on time because he cannot convert them into cash on time. This also applies to companies. Therefore, it is so important to understand what liquidity is and acquire assets in accordance with its normal level for the industry and the state.
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