Understanding Liquidity: Definition and Types of Liquidity

Liquidity in finance refers to the level of ease with which you can sell an asset, interest, or security without affecting its price. High liquidity means that an asset can be easily converted to cash for the expected value or market price. Low liquidity means that markets have few opportunities to buy and sell, and assets become difficult to trade. The liquidity of an asset can also refer to how quickly it can be converted to cash because cash is the most liquid asset of all. You can calculate a company or person’s liquidity position through ratio analysis, which compares an entity’s assets against their liabilities. An entity is solvent if their total assets are higher than their liabilities, meaning that they can pay their debts and still have working capital left over.

Here is a brief overview of the three types of liquidity.

1. 1. Asset liquidity: The liquidity of an asset refers to how easily that asset can be converted to cash when it is bought or sold. Cash is the highest liquidity asset because it can be traded easily and quickly without any effect on its market value. Stocks and bonds are also considered highly liquid assets, although their liquidity can vary depending on the popularity and reliability of the stock. Examples of illiquid assets include real estate and high art, as although they're highly prized they can be more difficult to sell and their price fluctuates with the market.
2. 2. Market liquidity: Market liquidity refers to the conditions of a market in which an asset can be bought or sold. If market conditions support a high number of buyers and sellers, the market has high liquidity because it is easier to buy or sell your asset at the price you want. Illiquid markets are financial markets in which there are fewer buyers or sellers—for example the market for rare collectibles—which makes it harder to sell assets at your desired price. During periods of financial crisis, stock markets become less liquid.
3. 3. Accounting liquidity: Accounting liquidity refers to a company's ability to pay off financial obligations such as marketable securities, cash, inventory, and accounts receivable. Investors looking at a company's stocks often consider the company's accounting liquidity, because this can convey the state of a company’s financial health.

Ratio analysis is a series of equations that calculate the solvency of a company or individual by comparing their assets against their liabilities. Here is a brief overview of three types of liquidity ratios.

1. 1. Current ratio: Calculating the current ratio of a company or individual is the simplest and most common way of measuring liquidity. The current ratio looks at a company's total current assets—cash assets and otherwise—against their total current liabilities like debt obligations. The equation for current ratio is: Current ratio = Current Assets / Current Liabilities.
2. 2. Quick ratio: The quick ratio takes higher liquidity assets into account than the current ratio does. The quick ratio considers a company's cash and cash equivalents, short-term investments, and accounts payable against their current liabilities. Here is how to calculate a party’s quick ratio: Quick Ratio = (Cash and Cash Equivalents, Accounts Payable, Short-Term Investments) / Current Liabilities. The acid-test ratio is a variation on the quick ratio, subtracting inventories and prepaid costs from current assets. Here is how to calculate the acid-test ratio: Acid-test Ratio = (Current Assets - Inventories - Pre-paid costs) / Current Liabilities.
3. 3. Cash ratio: The cash ratio is the strictest means of measuring a company's liquidity because it only accounts for the highest liquidity assets, which are cash and liquid stocks. Here is how to calculate cash ratio: Cash Ratio = (Cash and Cash Equivalents, Short-Term Investments) / Current Liabilities.

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