Liquidity of Stock Market

What is Liquidity of Stock Market?

Liquidity describes the extent to which an asset or security that can be quickly bought or sold in the market at a price that reflects its intrinsic value. In other words: the ease of turning it into cash. Cash is universally considered the most liquid asset, while tangible assets, such as real estate, fine arts, and collectibles, are all relatively illiquid. Other financial assets, ranging from equities to partnership units, fall in various places in the liquidity spectrum. Cash is considered a standard of liquidity because cash can be quickly and easily converted into other assets.

If someone wants a $10,000.- refrigerators, cash is the easiest asset to get it. If the person does not have cash but a collection of rare books which has been valued at $10,000.-, he might not find someone who would exchange them for a refrigerator for their collection. Instead, he had to sell his collection and use cash to buy a refrigerator. That might be fine if the person can wait for months or years to make a purchase, but it can cause problems if the person only has a few days. He may have to sell the book at a discount, instead of waiting for a buyer who is willing to pay on full value. Rare books are examples of illiquid assets.

Market Liquidity

Market liquidity refers to the extent to which markets, such as a country's stock market or municipal real estate market, allow assets to be bought and sold at stable and transparent prices.

In the example above, the market for refrigerators in exchange for rare books is so illiquid that, for all intents and purposes, none exists. The stock market, on the other hand, is characterized by higher market liquidity. If the exchange has a high trading volume that is not dominated by sales, the price offered by the buyer per share (bid price) and the price that the seller is willing to accept (ask price) will be close enough to each other. Investors, therefore, will not have to surrender unrealized profits for fast sales. As the spread between the bid and ask prices grows, the market becomes more illiquid.

The market for real estate is usually far less liquid than the stock market. Market liquidity for other assets, such as derivatives, contracts, currencies or commodities, often depends on their size, and how many open exchanges can be traded.

Accounting Liquidity

Accounting liquidity measures the ease of a person or company to fulfill their financial obligations with liquid assets available to them - the ability to pay off debt when due. In the example above, rare book collector assets are relatively illiquid and may not be worth the full value of IDR 10 million in an emergency.

In investment terms, valuing accounting liquidity means comparing liquid assets with current liabilities, or financial liabilities that are due in one year. There are a number of ratios that measure accounting liquidity, which differ in how tightly they define "liquid assets." Analysts and investors use this to identify companies with strong liquidity.

Measuring Accounting Liquidity

Generally, in using this formula, a ratio greater than one is desirable.

Current ratio

The current ratio is the simplest and least strict. It measures current assets (which can naturally be converted into cash in one year) against current liabilities. The formula is:

Current Ratio = Current Assets / Current Liabilities

Acid-Test / Quick Ratio

Acid-test or quick ratio is a little tighter. Excludes inventory and other assets, which are not as cash and accounts receivable, and as short-term investments. As a formula:

Acid-Test Ratio = (Cash and Cash Equivalents + Short-term Investments + Accounts Receivable) / Current Liabilities

The variation of Acid-Test only reduces inventory of current assets, making it a little more generous:

Acid-Test Ratio (Var) = (Current Assets - Inventory - Prepaid Expenses) / Current Liabilities

Cash Ratio

Cash ratio is the most appropriate liquidity ratio. Excluding accounts receivable, as well as current inventory and other assets, it strictly defines liquid assets as cash or cash equivalents. More than the current ratio or acid-test ratio, it assesses the ability of an entity to remain liquid in an emergency case - the worst case scenario - on the grounds that even very profitable companies can run into problems if they do not have the liquidity to react to unexpected events. The formula:

Cash Ratio = (Cash and Cash Equivalents + Short-term Investments) / Current Liabilities

Liquidity in the Stock Market

In terms of investment, equity as a class is one of the most liquid assets. But not all equity is created equal when it comes to liquidity. Some shares are traded more actively than others on the stock market, meaning there is more market for them - they attract greater interest, more consistently from traders and investors, in other words. These liquid stocks can usually be identified by their daily volume, which can amount to millions of shares, or even hundreds of millions.