Liquidity
Liquidity is a key indicator in the economy that implies the ability to quickly sell an asset (goods, raw materials, loans, investments) at the market price without losses. This concept can be applied to absolutely different objects - transport, securities (stocks, bonds), real estate and money (in the case of currency exchange).
Liquidity explained
Any company has debts and assets but if the number of assets is higher, then the organization can be considered liquid. That is, it is able to easily sell the property belonging to it and solve the issue of debts.
The liquidity ratio directly reflects the solvency of the enterprise and, as a rule, it is what banks pay attention to before granting credit. This parameter is also important in other cases, for example, when investing and buying stocks, as well as when choosing partners for cooperation as any company is interested in working with a liquid business capable of delivering goods in time and providing services without advance payment.
Liquidity classification
Liquidity is the ability of assets to turn into money without loss. It comes in three types:
- high;
- medium;
- low.
High liquidity assets: securities, deposits in banks, goods that can be sold in a short period of time (including currency) for the greatest profit, for example in one day;
Medium liquidity assets: real estate and goods which can be sold within a week;
Low liquidity assets: goods, low-value shares, which will take several weeks to sell.
In addition, liquidity can be divided into current, rapid and absolute.
Current liquidity. This refers to a company's current position - whether it can pay off its assets in the form of short-term investments without selling its assets. The current ratio is calculated using the formula: the amount of assets divided by the current liabilities. The result will be the current liquidity ratio.
It is considered normal if it is in the between 1.5 to 2.5. If the resulting number is less than 1.5, then the company is illiquid and, most likely, if creditors demand the return of debts, it will have to say goodbye to its assets.
Rapid liquidity. Quick liquidity reflects an organization's ability to resolve debts immediately. In addition to short-term investments, accounts receivable and account balance are taken into account here. This is reflected in the formula as follows: accounts receivable are added to short-term investments and account balance and then divided by liabilities. This results in a quick liquidity ratio.
If the final value is below 0.7, then the company needs to increase its assets.
Absolute liquidity. In the case of absolute liquidity, only the account balance and short-term investments are used to calculate the ratio. In the formula it looks like this: investments are added to the account balance and divided by liabilities. The result is the absolute liquidity ratio.
The normal result is above 0.2. If it is lower, it will not be possible to close debts quickly.
Classification of Liquidity by area of application
The concept of liquidity can be used in different spheres. On this basis, the following types can be distinguished:
- money;
- assets;
- banks;
- markets;
- enterprise;
- international.
Liquidity of money. One of the most perfect and most demanded in its essence of liquidity, which implies an instant exchange of money for any good or service. That means a person has the ability to freely pay with it or keep it at his or her discretion. In countries with stable economies, money has the highest liquidity.
Liquidity of assets. Liquid assets are those in demand on the market and can easily be turned into money. It refers to goods, projects, patents, and generally anything else that can make a profit for the firm.
Liquidity of banks. This refers to a bank's ability to fulfill its financial obligations. Sometimes it happens that the Central Bank imposes fines on a credit institution for failure to comply with norms. If a financial institution is liquid, its position is stable.
Liquidity of markets. If in the case of goods, liquidity means a quick and profitable exchange for money in a short period of time, then the liquidity of the market is a degree of creating conditions to enable such an exchange - for example, a sufficient number of sellers and buyers, stable prices, etc.
Enterprise liquidity. If an enterprise easily manages its debts, then it is liquid.
International Liquidity. Similar to companies, countries also meet their external obligations and pay their debts on time. In addition, international liquidity is related to the security of the global monetary system.
