What is Liquidity?

Liquidity is a feature of an asset which makes it easily convertible into cash. An asset or security that can easily be purchased, sold, or converted into cash has liquidity. 

Cash itself is a liquid asset, while savings accounts, checkable accounts, assets and securities that are easily changed into cash are also considered liquid.

In accounting, liquidity has a variety of meanings. Accounting liquidity might refer to the ability of a borrower or debtor to settle all debts when due. For companies and businesses, accounting liquidity often refers to the ease with which all financial obligations and liabilities of the business are met. 

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;

• Acid-Test/Quick Ratio

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.

• Current Ratio

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.

• Cash Ratio

The cash ratio is calculated as: Cash Ratio = (Cash and Cash Equivalents + Short-Term Investments) / Current Liabilities When the cash ratio 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.

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