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Liquidity in the Finance Markets: Everything to Know

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Synopsis:

Liquidity is one of the most important concepts in financial markets. It means how easy or difficult it is to sell an asset and convert it into cash without impacting its price much. If an asset has high liquidity, it means it can be converted into cash easily. Conversely, if an asset has low liquidity, it shows that it can’t be converted into cash with great ease.

 

Typically, stocks of blue-chip companies have high liquidity because such companies enjoy a good reputation in the market. Similarly, bonds with a high credit rating have high liquidity because the issuer of such bonds can pay interest and principal due on time.

When you have an asset, you are naturally concerned about its price. You like to know how much money you will make by selling it. However, a question, which investors often ignore is: How easily can they sell their asset?

In the finance market, liquidity means how easy or difficult it is to sell an asset for cash without significantly impacting its price.

Read this blog, as it explains what liquidity is, types of liquidity, how it affects the market, and many other aspects related to it.

What is Liquidity?

Let’s understand the meaning of liquidity. It means how easy it is to sell an asset in the market to convert it into cash. After all, we all buy assets with an intention to sell them to make money. If you can sell an asset easily without affecting its price much, such an asset is called highly liquid. On the other hand, if it is very difficult to convert an asset into cash by selling it without impacting its price, that asset is highly illiquid.

Here, we should understand why we should be able to sell an asset without impacting its price much. Suppose you bought a piece of land for Rs. 1 crore. After a year, hardly anyone is willing to buy it from you. Hence, you decide to take a 20% cut and are willing to sell it at Rs. 80 lakhs. While you are able to sell it, you have to take a big price cut. Therefore, this asset will be considered illiquid. Hence, this is an important aspect of liquidity. Having understood what liquidity is, let’s delve deeper into this topic.

Types of Liquidity

There are three types of liquidity:

  1. Asset liquidity: This means how easy it is to convert an asset into cash. In the example given above, the piece of land is an illiquid asset. The most liquid asset is cash because you can use the cash you have and buy anything from it in the market. Certain assets are highly liquid. For example, stocks which trade in high volumes tend to be highly liquid.

  2. Market liquidity: Market liquidity means whether a market has enough scope for a high number of buyers and sellers to operate. For example, the stock market has millions of buyers and sellers, which means it has high liquidity. However, the market of rare paintings typically has only a few buyers and sellers. Hence, it has low liquidity.

  3. Accounting liquidity: This means whether a company has assets, which can be quickly converted into cash, to pay its obligations. Such assets include cash, cash equivalents, marketable securities, debtors, and inventory.

Having understood the meaning of various types of liquidity, let’s move on to how it affects financial markets.

How Liquidity Affects Financial Markets

Liquidity is one of the most important factors in a financial market. Let’s understand it with an example. In India, often people living in big cities buy holiday homes in remote locations. Such places tend to have fewer people. While you may buy a property there, you may not be able to sell it easily because there are fewer buyers. So before making any sort of investment, we should check whether we will be able to liquidate or sell it or not.

If we are not able to sell an asset, we are taking a significant risk by buying it. Similarly in the stock market, certain shares are sometimes available at an extremely low price. You may get tempted to buy them, but there’s no point in doing that if you can’t sell them easily.

Measuring Liquidity

To measure a company’s liquidity, we use certain ratios, which assess whether a company can easily use its liquid assets to pay its obligations which are due soon. These ratios include:

  1. Current Ratio: It is calculated by dividing a firm’s current assets by its current liabilities.

  2. Quick Ratio: For this ratio, we exclude certain current assets which can’t be converted into cash that easily. So, we typically exclude inventories from current assets. Quick Ratio = (Cash + Assets like Cash + Marketable Securities + Debtors) / Current Liabilities

  3. Cash Ratio: For this ratio, we consider only cash and cash equivalents of a firm and divide them by its current liabilities.

Factors Influencing Liquidity

The prominent factors that affect liquidity are discussed below:

  1. Information symmetry: If sufficient information is available about an asset and is almost equally available to all investors, then it’s likely that there will be a sufficient number of buyers and sellers for that asset, and vice versa.

  2. Level of debt in a company: If a company has a huge debt and is finding it difficult to pay interest expense, then it will have low accounting liquidity. This may even result in fewer people willing to buy and sell its shares. Hence, the market liquidity of its shares will be affected as well.

  3. Money supply in an economy: Typically, when the money supply is high in an economy, sufficient funds are available for people to undertake various economic activities. This often results in a high number of buyers and sellers for various assets. However, if the money supply is low, liquidity is less.

Benefits of High Liquidity

  1. Benefits for an individual: If you own a highly liquid asset, you’ll be able to sell it easily in the market. Besides, it’s highly likely that you’ll be able to get a fair price for it. When an asset has a significant number of buyers and sellers, chances are high that you’ll get a fair price for it.

  2. Benefits for a firm: When a firm has high liquidity, it means that it can pay its short-term obligations easily. This will provide peace of mind to its management. Besides, if a firm can pay its obligations in time, it can improve its reputation, which in turn, can help it to borrow at a low interest rate.

Risks of Low Liquidity

  1. Risks for an individual: If you own an illiquid asset, you will find it tough to sell it. You may get stuck with it, which will cause you agony. Or, you may have to sell at a huge discount, which will cause you a financial loss.

  2. Risks for a firm: A firm with low liquidity finds it tough to pay its short-term obligations in time. It may even default on paying its short-term loans. This can badly affect its reputation among the lenders. They may even start asking the firm to pay a much higher interest for its borrowings in the future.

Liquidity in Different Financial Instruments

Let’s discuss the liquidity of various kinds of financial instruments in India. Money market instruments, which include short-term financial assets with one year or less maturity tend to have high liquidity. Examples of such instruments include certificates of deposit (CD), treasury bills issued by the Indian Government, and commercial papers issued by corporations.

Blue chip stocks tend to have high liquidity. These stocks belong to large companies, which tend to have a good reputation. Hence, there are many buyers and sellers for such stocks. Meanwhile, certain types of bonds (especially with a low credit rating) tend to have low liquidity. In the case of such bonds, people don’t know whether the issuing company will pay interest and principal due on them. Hence, they aren’t willing to trade in them, causing low liquidity.

Strategies to Manage Liquidity in the Financial Market

Firms and individuals can manage liquidity if they plan for it. For example, a firm should estimate its cash flows realistically. If it knows with certainty that some of its obligations are due within a year, it should plan its cash inflows in such a manner that it can pay for those obligations.

Whether you are a firm or a person, you should have some cash reserves only for contingencies. No matter how good you are at predicting, certain obligations may arise out of nowhere. To deal with them, a cash reserve will certainly help.

While you should have cash reserves, you should not keep all the money meant for a reserve in the form of cash because you won’t earn any interest on it. Instead, you should invest a part of it in short-term, highly liquid, good-quality instruments so that you earn some interest on them and you should be able to sell them if need be.

Conclusion

Having understood what liquidity is, you’d agree that it’s one of the most important aspects of financial markets. When firms and individuals make financial decisions without thinking about liquidity, they often make mistakes.

Hence, we all have to think about the liquidity of our assets and our businesses. For this, we should estimate our cash inflows and outflows at the beginning of a financial year. We should also maintain a reserve for contingencies.

To keep a tab on the stock market’s liquidity, we should closely follow its developments and listen to the views and opinions of experts.

Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.

This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.

For All Disclaimers Click Here: https://bit.ly/3Tcsfuc

Frequently Asked Questions

What is liquidity in the context of financial markets?

Answer Field

In financial markets, liquidity means how easily you can sell an asset without impacting its price much.

How does liquidity impact market efficiency?

Answer Field

If a market has many buyers and sellers (which means it’s highly liquid), it will be able to price securities in a fair manner because several buyers and sellers are involved. Such a market will tend to be efficient.

What are the different types of liquidity?

Answer Field

Three types of liquidity exist. Asset liquidity refers to how easy it is to convert an asset into cash. Market liquidity shows whether a market has enough place for a high number of buyers and sellers. Accounting liquidity means whether a firm has sufficient liquid assets to pay its short-term obligations.

How can I measure liquidity in financial instruments?

Answer Field

You can measure or assess a financial instrument’s liquidity by analysing how easy or difficult it is to sell it without affecting its price much.

What factors influence liquidity in the financial markets?

Answer Field

Money supply, debt levels of companies, credit ratings, and information asymmetry are some factors that impact liquidity in the financial markets.

What are the risks associated with low liquidity?

Answer Field

If you have invested in an asset with low liquidity, you may not be able to sell it. If a firm has low liquidity, it may not be able to pay its short-term debt.

How can investors manage and improve liquidity in their portfolios?

Answer Field

Investors can do so by buying instruments of those entities which have a high reputation or creditworthiness. For example, a highly rated bond (AAA credit rating) tends to be highly liquid because its issuer can pay the interest and principal due easily.

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