What is liquidity?

Here’s a closer look at what liquidity is, how to measure it, and why it’s an important consideration for any investor when assessing a company.

World globe being held up by stream of water representing liquidity
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What is liquidity?

An individual company’s liquidity refers to its ability to pay off any debts held as they become due. Debts (in the form of corporate bonds) are not usually homogenous. A company might have a bond payable in two months or 10 years. Liquidity typically refers to the ability of the company to pay off its ‘due and payable’ debts rather than the total value of its debt load.

This is obviously a crucial consideration for any investor, as there is only one consequence when a company cannot meet its obligations as a debtor – bankruptcy.

What do we mean by ‘liquid asset’? 

The liquidity of an asset refers to how readily it can be converted to cash at a price consistent with its value. 

ASX shares are normally considered to be highly liquid because they can be bought and sold in seconds. In contrast, a property is regarded as a relatively illiquid asset because of the cost and time it takes to sell on the market. 

If there is a consistent supply of willing buyers and sellers in a market, it is a fair indicator that an asset can be considered liquid.

All ASX shares are technically liquid, but some are more liquid than others. An ASX blue-chip share like Commonwealth Bank of Australia (ASX: CBA) has a large market capitalisation, a relatively large supply of shares outstanding, and usually attracts a large volume of share transactions during a typical trading day. Because of all these factors, CBA shares can be considered highly liquid.

In contrast, an ASX company with a small market capitalisation, such as shares outside the S&P/ASX 200 Index (ASX: XJO) or the All Ordinaries Index (ASX: XAO), will usually offer far less liquidity for investors. 

That’s because fewer investors are trading a smaller volume of shares on an average trading day. As such, investors might not find it easy to buy or sell these shares efficiently at a consistent market price. They may also find that a large buy or sell order can significantly move the share price in a lopsided manner.

Because of these factors, small-cap ASX shares are often described as more illiquid by comparison.

Liquidity ratios 

There are conventionally two methods when measuring a company’s liquidity: the current ratio and the quick ratio.

Current ratio 

The current ratio measures a company’s ability to pay off its existing debts or liabilities (usually those payable within one year) with all its current assets – liquid or illiquid. These assets might include cash, credit owed by other parties, or product inventories.

Whilst this method is the most comprehensive, it has its problems. For example, a company may technically have an asset that can offset a debt, but some assets, like inventories, are hard to sell quickly. Therefore, in practical terms, an inventory is not readily convertible to cash to pay off a company’s debts. As such, a company’s current ratio is best analysed in conjunction with its quick ratio.

How to calculate the current ratio

The current ratio can be calculated with a simple formula:

Current Ratio

Quick ratio

Typically, a current ratio above one is considered ‘good’, as it indicates a company has more assets than liabilities on its balance sheet. Conversely, suppose a company has a current ratio below one. In that case, it indicates that the company’s liabilities or debt obligations are higher than the value of the company’s assets, which is an ‘orange flag’ for investors, to say the least.

The quick ratio (also known as the ‘acid test ratio’) is similar in concept to the current ratio but excludes assets that lack sufficient liquidity of their own to service a company’s short-term debt obligations, such as inventories. 

These assets might technically bolster a company’s balance sheet on paper, but in practice, they can’t be readily sold to fund debt repayments. In this way, the quick ratio is a more conservative metric for company evaluation than the current ratio.

How to calculate the quick ratio

There are several formulas that are conventionally used to calculate the quick ratio of a company. Here are a few:

Quick Ratio Formula

As with the current ratio, a quick ratio of one or more indicates a company has more assets than liabilities, and a quick ratio below one indicates more liabilities than assets. 

How should we use liquidity ratios?

On their own, the quick and current ratios are not silver bullet solutions to assessing companies. They should be used in conjunction with other metrics and analysis. 

Either ratio, on its own, may not give an investor a complete picture of the health of a company. It may ignore a concerning debt load that might not be due and payable in the near term. It may also unnecessarily ring alarm bells over shareholder-friendly activities, such as paying a special dividend.

Using the quick and current ratios to evaluate a current or potential investment is a great exercise. But it is where the story should start, not conclude.

Last updated 21 April 2022. Motley Fool contributor Sebastian Bowen has no position in any of the stocks mentioned. The Motley Fool Australia’s parent company Motley Fool Holdings Inc. has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.