#008: On liquidity
Author’s Note
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Suppose, an individual wants to purchase headphones worth ₹10,000. Cash is the asset that can be readily used to obtain it. If that person has no cash but a rare book collection that has been appraised to ₹10,000, the person might not be able to find someone willing to trade headphones for that book collection. Instead, they will have to sell the collection and use the cash to purchase the headphones. That may be fine if they can wait for months or years to make the purchase, but it could pose a problem if they only had a few days in hand. They may have to sell the books at a discount, instead of waiting to find a buyer who is willing to pay the full value. Rare books are an example of an illiquid asset.
Liquidity is important for individuals, corporations, as well as markets. Despite of holding high-value assets, any of these entities may experience liquidity crunch if such assets cannot be converted into cash within a short span of time. It may so happen that there may be distress selling of assets in order to meet the liquidity demands or short-term obligations.
What is Liquidity?
Liquidity relates to quick access to cash. Individuals hold assets or security, and liquidity refers to the ease with which these may be bought or sold in the market for conversion into cash, either to spend or to invest. It also determines how easily you can sell an asset and at what price, should the need to do so arises. All asset classes have varying degrees of liquidity. Cash is held to be the standard for liquidity as it can be converted to other assets most easily.
One of the important ways to calculate liquidity is:
Liquidity ratio
Emergency fund ratio or liquidity ratio is a personal finance ratio that measures the ability of a household to meet expenses out of the assets that can be easily converted into cash. It is computed by dividing the total liquid assets of the household by the total monthly expenses of the household. This ratio should always be more than 1 which indicates that assets are more than liabilities/expenses.
Factors that determine liquidity
Time
The lower the time taken to convert an asset to cash, the more liquid the asset and vice versa. Examples of liquid assets include bank fixed deposits, listed equities and open-ended mutual funds. Whereas, real estate and long-term debt and other types of equity investments fall under the 'illiquid' category.
Cost of Conversion
Additionally, the lower the cost incurred to convert the instrument to cash, the more liquid the asset. Some assets have penalty or applicable exit load which adds to the cost for example mutual funds. The withdrawal restrictions imposed by banks or mutual funds can be catastrophic if you need the money for immediate use in an emergency.
Price Movement
The lower the price fluctuation in a quick sale of an asset the more liquid the asset. Liquid equity stocks can be sold without significantly lowering its price like the index stocks.
Why is there a need to take liquidity into account?
In personal finance and financial planning, it is recommended to maintain an amount equal to six months’ expenses worth in liquid assets for emergencies.
Experts believe it makes sense to keep some portion of your emergency fund in hard cash at home. Savings bank accounts are easily accessible for urgent cash requirements too. The covid-19 crisis has been testament to this, as many found themselves strapped for urgent cash or suffered setbacks such as job loss, pay cut, medical emergencies etc. In times of crises, emergency funds and liquid assets can be of great help.
Ask yourself questions that account for liquidity before planning your decisions. The plan should address key questions, including:
What is possible?
What is my budget?
Are there alternative funding sources available?
What is my back-up plan?
What are the risks if market volatility impacts valuation or the timing of an exit?
Do I have enough capital and/or liquidity to withstand the volatility of the market?
What is the capacity of the financial partner, bank, or other to lend?
Do I have any other assets that could support a loan?
If markets are not liquid, it becomes difficult to sell or convert assets or securities into cash. You may, for instance, own a very rare and valuable family heirloom appraised at ₹900,000. However, if there is not a market (i.e. no buyers) for your object, then it is irrelevant since nobody will pay anywhere close to its valuation - it is very illiquid. It may even require hiring an auction house to act as broker and track down potential interested parties, which will take time and incur additional costs. Liquid assets, however, can be easily and quickly sold for their full value and with little cost. Companies must also hold enough liquid assets to cover their short-term obligations like bills or payroll or else face a liquidity crisis, which could lead to bankruptcy.
FAQs
What are the most liquid assets or securities?
Cash is the most liquid asset followed by cash-equivalents, which are things like money markets, CDs, or time deposits. Marketable securities such as stocks and bonds listed on exchanges are often very liquid, and can be sold quickly via a broker. Gold coins and certain collectibles may also be readily sold for cash.
What are some illiquid assets or securities?
Securities that are traded over-the-counter (OTC) such as certain complex derivatives are often quite illiquid. For individuals, a home, a timeshare, or a car are somewhat illiquid as it may take several weeks or months to find a buyer, and several more weeks to finalize the transaction and receive payment. Moreover, broker fees tend to be quite large (e.g., 5-7% on average).
Why are some stocks more liquid than others?
The most liquid stocks tend to be those with a great deal of interest from various market participants and a lot of daily transaction volume. Such stocks also tend to attract a larger number of market makers who maintain a tighter two-sided market. Whereas, illiquid stocks have wider bid-ask spreads and less market depth. These names tend to be lesser-known, have lower trading volume, and often also have lower market value and volatility. Thus the stock for a large multi-national bank will likely to be more liquid than that of a small regional bank.
Key takeaways
Liquidity refers to the ease with which an asset, or security, can be converted into ready cash without affecting its market price.
Cash is the most liquid of assets while tangible items are less liquid. The two main types of liquidity include market liquidity and accounting liquidity.
Current, quick, and cash ratios are most commonly used to measure liquidity.
That’s it for today dear reader. See you next week. You can also follow us on Instagram.