Liquidity (Accounting) - Explained
What is Liquidity?
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Table of ContentsWhat is Liquidity?How Does Liquidity Work? Market LiquidityAccounting LiquidityMeasuring Accounting LiquidityAcid-Test/Quick RatioCurrent RatioCash RatioReal World Example of LiquidityAcademic Research on Liquidity
What is Liquidity?
Liquidity is a feature of an asset or security which makes it easily convertible into cash. An asset or security that can easily be purchased, sold, or converted into cash has liquidity. The conversion od an asset into cash shows the underlying or intrinsic value of the asset, Cash itself is a liquid asset, while savings accounts, checkable accounts, assets and securities that are easily changed into cash are also considered liquid.
Back to: ACCOUNTING, TAX, & REPORTING
How Does Liquidity Work?
There are varieties of assets and securities that are regarded as liquid, however, cash and cash equivalents are the most basic forms of liquid instruments. The benchmark for liquidity regardless of what the setting is is cash, this is because, with cash, any asset, tangible o intangle can be purchased or sold. Here are the major points about liquidity you should know;
- Liquidity is the quality of an asset or security that makes it easily convertible to cash.
- When an asset can be easily converted into cash, it is liquid. Not all assets are liquid, in most cases, intangible assets are illiquid.
- Liquidity reflects the intrinsic value of an asset.
- Cash is the standard and most basic form of liquid assets.
- Liquidity can be measured in assets or securities using a variety of techniques.
Market liquidity refers to a state of the market that allows easy sale and purchase of assets and securities at a transparent price. Whether it is a security market or real estate market, market liquidity is a feature that allows market participants to sell and buy assets or items without causing a change in price. All markets do not have the same level of liquidity, some markets are more liquid than the others. Liquidity can also refer to how large trades can be pulled off in the market, the speed at which the sales are executed and the price. In most market settings, the stock market is liquid than other markets such as real estate markets that are less liquid.
In accounting, liquidity has a variety of meanings. Accounting liquidity refers to the ability of a borrower or debtor to settle all debts when due. For companies and businesses, accounting liquidity refers to the ease with which all financial obligations and liabilities of the business are met. The ability of individuals and organizations to pay short-term debts is measured through accounting liquidity. For companies, financial obligations are expected to be settled with the liquid assets available to the organizations, failure to settle those obligations result in accounting illiquidity. In investment, liquidity entails drawing comparisons between liquid assets and current liabilities (liabilities payable within one year), investors determine investments with high liquidity through several methods and ratios.
Measuring Accounting Liquidity
There are several formulas or ratios that are used in measuring accounting liquidity whether in companies or in the investment market, the most popular formulas are;
The formula for the acid test ratios is: Acid-Test Ratio = (Cash and Cash Equivalents + Short-Term Investments + Accounts Receivable) / Current Liabilities When using the acid-test ratio, current assets that are less liquid than cash and cash equivalents are not given priority, inventories are also excluded.
The current ratio uses the formula below: Current Ratio = Current Assets / Current Liabilities This formula is the simplest of all formulas for measuring accounting liquidity, it measures the current assets of a company against its current liabilities.
The cash ratio is calculated as: Cash Ratio = (Cash and Cash Equivalents + Short-Term Investments) / Current Liabilities When the cash rato is being used, only cash and cash equivalents qualify as liquid assets. Inventories, current assets and other forms of liquid assets are not included in the calculation.
Real World Example of Liquidity
In the real world, cash is the standard form of liquid assets, however, due to the expanse of ho liquid assets can be used, there are other assets that are liquid. With regards to investment, most liquid assets are equities because they can be easily traded on the stock exchange and converted into cash. As liquid as equities are, there are certain qualities that distinguish them which is why some are valued more than the other. Usually, the liquidity of equity is determined by how fast it can be traded on the stock exchange, the daily volume of the trade and the amount at which the equity is converted.
Academic Research on Liquidity