The term liquidity is used to determine economic efficiency in various fields of activity: business, real estate, management of securities and other property owned by an organization or an individual. Assessing the possibility of converting assets into cash equivalent at market value is one of the main indicators by which the current condition and solvency of any enterprise is judged.
What is liquidity?
Liquidity is the ability of an asset to be sold at the current market price. The economic term refers to the ability of an object to quickly turn into money. An asset is any property that is owned by an organization or an individual and has a market value: bank deposits, real estate, securities, goods, and so on.
ATTENTION!
The easier it is to exchange an object for money, the more liquidity it has.
That is, any thing can be recognized:
- highly liquid;
- low liquidity;
- illiquid.
For example, for equipment in a factory workshop this indicator will be low, since it is quite difficult to quickly sell it at current market prices. Money is considered the most liquid (self-liquidating). Also, a high rate is typical for securities and deposits, while a lower rate is typical for business and real estate. At the same time, the liquidity of the same financial instrument may differ (for example, for shares of different companies).
It should be taken into account that the indicator is assessed not only in relation to individual assets, but also to the enterprise and the market as a whole.
Explanation of the term
The concept of liquidity is important to consider for anyone actively involved in business or private investment. What is required here is not a strict economic formulation, but the disclosure of general principles.
Revealing what general liquidity is in simple words, we can say this: the ability of an asset to quickly turn into cash without losing its own value.
Economic characteristics are important when evaluating enterprises
The characteristic determines how long it will take to sell any asset at the market price. The shorter this period, the more liquid the asset will be.
A typical example of a highly liquid asset is currency. It can be exchanged at any time without losing the final value. Sometimes it is even called an asset with absolute liquidity. Real estate is often classified as low-liquidity assets, since it is difficult to quickly find a buyer for an apartment or house.
Liquidity in business
When doing business, it is important to constantly monitor the ability of the company's assets to be converted into money. In-depth analytics will help assess the performance of a particular organization and its stability in the market.
Ratios form the main parameter of the stability of any company: solvency. When buying a business, they immediately pay attention to liquidity. This information is then taken into account to estimate the value of the company.
The value of the indicator in business is an important factor
In the field of investment
Investment refers to the placement of free capital in a certain area to make a profit. Now many people and organizations are involved in investments, regularly analyzing the market, tracking down profitable positions.
Before investing, you need to obtain information about the company. This data will help the investor understand how long to hold money in a particular property, as well as enable them to predict the sale price.
Why evaluate a company's liquidity?
An assessment of a company's liquidity is necessary in order to identify the organization's solvency and the possibility of actually paying off existing debts. If a certain organization has a lot of money in its account, and there are stocks of quickly selling products in its warehouses, banks are much more willing to give it a loan. The same applies to possible deliveries without prepayment. Such a company will always be able to pay on time.
Without decent assets, it will be very difficult for an organization to obtain a loan or credit, since lenders are aware of the likelihood that they will not receive their funds back very soon. Low liquidity seriously reduces the chances of receiving additional injections.
Why is liquidity assessment so important?
The analytical indicator is primarily used to evaluate investment activity. When investing, it is important to obtain a profit that significantly exceeds the costs. But market changes, fluctuations in consumer demand, the economic situation in the country and other circumstances may cause a loss of invested capital.
To avoid a negative outcome, the investor needs to sell assets on time and redirect them to a new project. This can only be done if the object has sufficient liquidity.
ATTENTION!
For enterprises, analysis of this indicator allows one to establish the level of financial stability and business efficiency.
If a company has more working capital than hard-to-sell assets, this indicates its economic stability. Liquidity assessment is important in order to acquire objects in accordance with the acceptable level of the indicator for a particular application.
For example, a company may have rich assets, but will not be able to use them to cover short-term liabilities (due to difficulties in converting them into cash). This indicates low liquidity of the organization.
Liquidity Examples
The main examples in the context of which the concept of liquidity is most often used are discussed below.
Liquidity of assets in the stock market
The liquidity of exchange-traded instruments is one of the most important characteristics that investors primarily pay attention to when forming a portfolio. It allows you to estimate how quickly a particular asset can be sold at the market price. When determining liquidity, the following factors are taken into account:
- trading volume (the number of transactions made with a given asset);
- spread (the difference between the purchase and sale prices).
If a large number of transactions are made with a security, and the spread is minimal, then we can say that this asset is highly liquid. Simply put, it is easy to buy and easy to sell.
The most liquid assets in the stock market are shares of large companies (blue chips) and currencies. Bonds and shares of small enterprises are considered illiquid. Investors may wait several weeks for a favorable moment to sell these securities at the average market price.
Bank liquidity
Bank liquidity is an indicator that reflects the ability of a credit institution to fulfill its financial obligations on time and in full. That is, each bank must have a certain amount of available funds, which will be enough to repay debts to depositors and creditors.
This indicator is regulated by the Central Bank. Currently, there are 3 liquidity standards for Russian banks:
- Instant (H2). This standard limits the risk of a bank losing its solvency within one business day. Instant liquidity is defined as the ratio of a bank's assets that can be sold during the day (cash, marketable securities) to its liabilities, which, if necessary, must be repaid during the day (current accounts, demand deposits). The maximum value of the instant liquidity ratio is 15%. For example, if the total amount of funds placed on current accounts with a bank is 100 million rubles, then at least 115 million rubles must be in correspondent accounts and in the cash department of a credit institution.
- Current (H3). Regulates the risk of bank insolvency for 30 days. It is determined in the same way as the N2 standard, but in this case, assets (liabilities) that can be realized (required to be repaid) within the next 30 days are taken into account. The minimum value of H3 is 50%.
- Long-term (H4). Limits the liquidity risk of a financial institution that arises when investing in long-term assets (for example, mortgage loans). When calculating N4, assets with a maturity period of at least 1 year and liabilities that the bank must fulfill within the specified period are taken into account. The ratio should not exceed 120%.
Each credit institution is obliged to calculate these standards on a monthly basis and transmit the results to the Central Bank of the Russian Federation.
Liquidity of money
The liquidity of money refers to its ability to maintain its nominal value at the same level. Cash is generally considered the most liquid asset, as it can be used instantly to pay for goods and pay creditors.
Many countries around the world use such a monetary policy instrument as reserve requirements. Its essence lies in the fact that the regulator obliges credit institutions to invest in certain types of assets. In this particular case, the liquidity of money for the bank is reduced, since it cannot immediately use it to pay off its obligations.
Market liquidity
A market can be called liquid if transactions are regularly made on it. Goods traded on this market must be in high demand and offered in sufficient quantities. It is important that the offer price differs slightly from the price specified in the purchase application.
Assessing market liquidity allows you to understand how quickly you can exchange an asset or product for cash. The foreign exchange and oil markets are considered the most liquid, the real estate market and the car market are considered the least liquid.
Company liquidity
This indicator allows you to assess how solvent an organization is and whether it is able to pay off its obligations. For example, if a company has a large amount of available funds and large volumes of quickly sold goods, then one can judge its high liquidity. Under such conditions, the company can repay loan debts on time and pay contractors and suppliers on time.
And vice versa, if the company has no money in its account, and the only assets it has are old equipment, then the conclusion arises about an extremely low level of liquidity. It is unlikely that in such a situation the company will be able to pay off its debts.
To assess the liquidity of an enterprise, all its assets and liabilities are divided into 4 groups, which are discussed in the table below.
| Assets (by degree of liquidity) | Liabilities (by urgency of payment) |
| A1 - the most liquid (money in accounts, cash, short-term investments) | P1 - the most urgent (current financial obligations to contractors, employees or to the state) |
| A2 - quickly sold (goods, materials, receivables with a maturity of less than 12 months) | P2 - short-term (debt on loans and borrowings with a repayment period of less than 1 year, obligations to shareholders to pay dividends) |
| A3 - slowly sold (long-term accounts receivable, inventories) | P3 - long-term (debt on loans and borrowings with a repayment period of more than 1 year) |
| A4 - difficult to sell (non-current assets, that is, buildings, structures, equipment, patents, developments) | P4 - constants (equity) |
A company is considered liquid if A1, A2, A3 is greater than or equal to P1, P2, P3, and A4 is less than or equal to P4.
Why evaluate a company's liquidity?
To conduct and develop a business, most companies are forced to take out loans and attract funds from investors. In this case, financial institutions or individuals investing money must assess the organization’s solvency and its ability to pay off its debts.
To do this, the liquidity indicator of a specific enterprise and assets is analyzed.
For example, an organization has a constant significant cash flow reflected in its accounts, and its warehouses contain products that are easily sold. Such an enterprise is liquid and solvent, which means it will arouse interest among both credit institutions and investors.
Rating of assets by degree of liquidity
As a conclusion to the article about liquidity, I would like to consolidate the material and, for clarity, create a rating of assets by their liquidity.
Let me remind you that most assets can be distributed according to the degree of their liquidity - absolute (1 day), urgent (up to 1 week), highly liquid (up to 1 month), medium liquid (up to 1 quarter), low liquid (up to 1 year) and illiquid. If we list the most famous and popular assets, we will get something like this rating, from highly liquid at the beginning to illiquid at the end of the list:
- Cash and currency
- Cash in bank accounts (deposits) on demand
- Government bonds (OFZ) and municipal securities
- Other bank deposits and certificates
- Precious metals
- Bonds of large and well-known companies
- Shares of large and well-known companies (blue chips)
- Shares of second-tier companies
- Other company shares
- Economy and budget class real estate
- Elite real estate
- cars and equipment
- Industrial and commercial real estate
- Earth
- Profitable business
- Construction in progress
- Investments in medium-risk companies and projects
- Cryptocurrencies (Bitcoin, Ethereum, etc.)
- Venture investments
And that’s all about liquidity today, I hope you found the article useful and interesting. Add the article and site to your bookmarks. See you in new articles of the Tyulyagin project!
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Types of liquidity and their ratios
Liquidity is classified into types:
- current - the value of current assets is compared with the value of existing liabilities;
- fast - reflects what part of the debt the organization will be able to repay with money and investments;
- absolute - defines short-term debt obligations that the company can repay immediately.
To determine the organization's ability to pay off its debts, the liquidity ratio is calculated based on financial statements. The indicator reflects the ratio of the company's debts and working capital. For a specific type of liquidity, their coefficient is determined.
What is the purpose of assessing the liquidity of a company’s assets?
An assessment of the liquidity of a company's assets is performed to confirm the solvency of the company and the ability to cover existing debts using its property.
When a company's warehouses are full of goods and there are large sums of money on its accounts, it is less likely to require advance payment and it is easier to provide loans from banks, because there is a guarantee of subsequent payments.
Conversely, if the accounts are empty, and all the property consists of the ruins of factory buildings in the industrial zone, then the company is close to bankruptcy and will not be able to fulfill its debt obligations.
Current liquidity
The current liquidity (coverage) ratio is calculated as the ratio of current assets to short-term debts (current liabilities).
The formula used for calculations is:
KLT = BOTH / KO, where:
- KLT - current liquidity indicator;
- BOTH - current assets;
- KO - short-term liabilities.
That is, the indicator reflects the company’s ability to cover existing debts exclusively at the expense of current assets. The higher it is, the better the solvency of the company.
An indicator less than 1.5 indicates low liquidity. A coefficient from 1.5 to 2.5 is considered the best option. A value over 3 indicates the organization’s high solvency, but also an irrational distribution of capital (liquid assets significantly exceed liabilities).
What is the difference: liquidity, solvency and profitability
You can understand the financial condition of an enterprise using the concepts of liquidity, solvency, and profitability. They are interconnected and make it possible to get a clear picture of what is happening. But to do this, you will need to understand the similarities and differences between the concepts.
Liquidity and Solvency
Solvency is a broad concept. It determines the ability of a person or organization to pay off its debts not only from assets, but also from liabilities.
Solvency is a significant factor
If a citizen, after an unexpected demand from the bank to repay the loan ahead of schedule, can fulfill these requirements through savings, then he is recognized as solvent. If a person, even after selling all his property, needs borrowed funds to repay the loan, he is automatically declared insolvent.
The easier it is to sell assets at a good price, the more convenient it is to pay off liabilities in case of a difficult situation.
Liquidity and profitability
Profitability indicates whether assets are being managed effectively. It does not make a strict connection between financial instruments and their sources. A high indicator is extremely important for those organizations or citizens who are involved in investments.
The profitability indicator will help assess the profitability of investments. The simplest formula can be expressed as the ratio of net profit to the assets used to obtain it.
Quick liquidity
The quick ratio is calculated as the ratio of highly liquid current assets to short-term debt.
The calculation is made using the formula:
KLb = (DZk + FVk + O) / KO, where:
- KLb - quick liquidity indicator;
- DZk - short-term receivables;
- FVk - financial investments for a short period;
- O - account balance;
- KO - short-term liabilities.
ATTENTION!
Inventories are not considered current assets with high liquidity, since their sale will provoke high unprofitability.
The indicator reflects the company’s ability to cover existing debts if unexpected difficulties arise.
The activity of an organization is considered stable if the parameter is at least 1. The larger the value, the higher the liquidity.
Who Needs Total Coverage Ratio?
The total coverage ratio is a sign that shows whether a company can pay off current liabilities using only current assets, including money in the accounts and cash of the enterprise, equivalents, loans, cash investments, securities, etc. For “STS income” or “STS income minus expenses”, accounting calculates the coefficient using the formula: The amount of accounts receivable, financial balances, assets divided by short-term loans and borrowings and other short-term liabilities. Such an indicator will help adjust the company’s behavioral policy on a simplified system in order to extract greater profits at lower costs.
Absolute liquidity
The absolute liquidity ratio is calculated as the ratio of funds in the company's accounts and short-term financial investments to current liabilities.
The calculation is carried out according to the formula:
KLa = (O + FVk) / KO, where:
- KLA is an indicator of absolute liquidity;
- O - account balance;
- FVk - short-term financial investments;
- KO - short-term liabilities.
The norm at which an organization is considered liquid is an indicator value of 0.2.
Relationship between liquidity ratios
| Elements for calculation | The current ratio includes in the calculation | The quick liquidity ratio includes in the calculation | The absolute liquidity ratio includes in the calculation |
| Reserves | ✓ | — | — |
| Accounts receivable for up to one year | ✓ | ✓ | — |
| Short-term investments | ✓ | ✓ | ✓ |
| Money | ✓ | ✓ | ✓ |
| Short-term liabilities | ✓ | ✓ | ✓ |
| Optimal value | 1,5-2,5 | 0,8-1,0 | 0,2-0,5 |
Liquidity indicators reflect what proportion of obligations can be closed through the use of money in accounts and cash, receiving money from debtors, and selling inventories. For some areas, the norm of indicators may differ.
Rinald Sadykov , CEO of Terabit Digital:
“The liquidity ratio is a litmus test for how financially and tactically we are doing things right. When the liquidity ratio becomes less than one, this is a signal that not all is well, a reason to think and take action. It is necessary to pay attention to the debit-credit balance, as we are entering the danger zone. The average market norm for the liquidity ratio is 1-2. But since our agency is engaged in IT development and the entire business is built on people, for us a coefficient of 1-2 means the presence of critical risks. We try to keep it at a level from 3 to 6"
In practice, a situation may arise when some coefficients are normal and others are not. In this case, you can use the table to identify weak points:
| Current ratio | norm | norm | No |
| Quick ratio | norm | No | No |
| Absolute liquidity ratio | No | No | No |
| Problem | lack of funds | lack of cash and accounts receivable | lack of cash, accounts receivable and inventory |
Liquidity by area of application
The solvency of an organization is determined by the ratio of its debts to liquid assets in various areas of application. That is, property that can be quickly sold at current market prices is taken into account.
In financial statements, assets are classified into:
- Working capital - bringing income to the organization during the year (money, raw materials, financial investments for the year, and so on).
- Non-current - providing income for a long period (equipment, patents, long-term investments, and so on).
Since current assets are easier to sell, they are considered more liquid. It is customary to distinguish 4 groups of assets:
- A1 - the most liquid (money, short-term investments);
- A2 - soon to be sold (short-term receivables);
- A3 - slowly sold (inventories, VAT, long-term receivables);
- A4 - difficult to sell (non-current assets).
To determine liquidity, assets are correlated with the liabilities of the enterprise, that is, it is necessary to take into account liabilities. These include the organization's capital and borrowed funds.
Liabilities are classified:
- P1 - urgent liabilities up to 3 months (accounts payable);
- P2 - short-term up to 1 year (loans and credits for a short period, dividend arrears);
- P3 - long-term more than 1 year (long-term loans);
- P4 - sustainable (future income, own capital, reserves for future costs and payments);
That is, the classification is made according to the degree of urgency of making payments.
Let's summarize
1. Liquidity is the speed at which activation is converted into money. 2. A company's liquidity is its ability to pay off obligations to creditors. 3. Calculation of liquidity involves correlating groups of assets by speed of sale and groups of liabilities by urgency of payment. 4. Liquidity calculation shows prospects in the long term. 5. Increasing liquidity is possible by optimizing working capital, working with accounts receivable, increasing profits, redistributing the credit load and taking into account the company's capabilities for long-term investments.
Liquidity of money
A characteristic property of money is its self-liquidity - the national currency of countries with a stable economic situation has the highest value. The change in the indicator is due to inflation - with an increase in prices for goods simultaneously with a decrease in the purchasing power of financial resources.
That is, the high liquidity of a currency is indicated by its ability to maintain its nominal value without significant losses, and the absence of hyperinflation in the country. Money is the most sought-after asset in the entire world. The greatest liquidity is inherent in cash, slightly lower - funds on the current deposit.
Market liquidity
A market in economics (not to be confused with a bazaar) is a generalized concept of the sphere in which goods are exchanged for money, and money is exchanged for goods. This is the area in which purchase and sale transactions are carried out. One of the basic laws of a market economy is the free formation of prices for goods.
If the aggregate supply price of transactions completed on the market is approximately equal to the aggregate demand price, and such transactions are completed in sufficient quantities, then the market is called highly liquid.
Market liquidity is usually assessed by the ratio of the volume of goods sold to the volume of goods offered. This indicator is called “black” . The market is considered liquid if black is above 15.
Bank liquidity
The indicator is considered conditional and assumes the ability of a financial institution to pay clients who place deposit accounts with it.
ATTENTION!
To maintain liquidity at the required level, the bank must have constant reserves.
When issuing loans, inventories should not be significantly depleted. Reserves can be in the form of not only cash, but also stocks, bonds or other assets. If necessary, the financial institution will be able to quickly implement them, increasing liquidity to an acceptable level. The indicator is controlled by the Central Bank of the Russian Federation. Like other organizations, the bank must have non-current assets on its balance sheet.
Liquid securities
The indicator is assessed by trading volume and the size of the spread (the difference between the highest buy prices and the minimum sell prices). The object is shares, bonds, bills and other securities. The greater the number of transactions on them and the smaller the spread, the higher the liquidity.
The level of the indicator is determined by the demand for securities. That is, if you can quickly purchase or sell shares of a certain company without a significant change in price, such securities are considered highly liquid.
Real estate liquidity
Real estate is considered less liquid in comparison with money, securities, and products of the organization. Selling an object at a market price usually takes a long period, which includes an appraisal, searching for a buyer, completing a transaction, and so on. In some cases, to speed up the sale, you have to lower the price.
The price is strongly influenced by external factors (location, condition, technical parameters, purpose of the property). This explains the difference in liquidity levels of similar objects.
However, real estate is not a low-liquidity asset. For individuals, investing in it may be more profitable than a bank deposit in case of an unstable economic situation in the country (hyperinflation, denomination, etc.) or an amount exceeding 1.4 million rubles.
The profitability of real estate increases when the property is rented out, but it will begin to generate profit only when its purchase pays off.
What is it in simple words
In simple terms, it is the extent to which an asset or security can be sold in the market at its fair market price. Or in other words, convert into cash or another asset.
For example, stocks are a good example of a highly liquid asset. For others (for example, real estate or land), an urgent sale at market price is difficult. You need to either lower the price or wait until someone finds you who will accept your price. It takes weeks or months to sell, making the asset less liquid.
Why is it important to know liquidity?
Having soberly assessed the parameter, we get an understanding of how easy it is to turn an asset into “useful” money. For long-term investors this is not so important. Stock traders, on the contrary, need to invest in highly liquid assets, since only these can be quickly and efficiently converted into hard cash without sacrificing value.
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What has the least and greatest liquidity?
In short, free money (cash or bank account) has the highest liquidity. Material investments (real estate, land, luxury goods and collectibles) are relatively illiquid.
Other financial instruments (for example, shares and bonds) have different levels, which depend on the issuer.
For example, if a person wants to buy a refrigerator for 20,000 rubles, cash is the asset that is most easily converted into goods. If we have money, we buy it right away. If there is no money, but there is a collection of rare books of equivalent value, it is unlikely that there will quickly be someone who wants to exchange them for a refrigerator.
First, the books will have to be sold in order to use this amount to buy a refrigerator. This is very inconvenient, because you can wait a long time for a person willing to pay the full price. Another option is to reduce the price. And this is also unprofitable.
Liquidity of the enterprise
The indicator for a specific organization is determined on the basis of the balance sheet. If it is liquid, then this characteristic corresponds to the enterprise. That is, to determine the organization’s ability to quickly repay debt, the ratio of assets and liabilities and the ability to convert the former into money are assessed.
The liquidity of an enterprise for creditors and investors is synonymous with its solvency. When determining this indicator for a separate organization, it is advisable to establish it for various types of assets involved in economic activities.
How is the liquidity of an asset determined?
The key indicator in determining the liquidity of assets is time. It all depends on the specific number of days (time period) that the company requires to sell the object and receive money for it. The asset turnover rate creates the main liquidity grouping. All property and other assets of the company are classified into certain groups, depending on the turnover rate.
The classification begins with absolutely or the most liquid assets - these are funds that can be instantly withdrawn, for example, cash on hand or finances in the current accounts of an organization. That is, the money itself. Their turnover rate is minimal. You can receive cash on the day you go to the cash register or transfer payment for goods by payment order from your current account. The owner of an absolutely liquid asset does not waste time “transforming” it into a solvent object, but simply pays with it.
On this basis, the level of financial and economic stability of the enterprise and the degree of its solvency and operating efficiency are determined.
Balance sheet liquidity
The assessment of the indicator for the balance sheet is calculated as the ratio of debt and liquid funds. That is, it shows how much one can cover liabilities with assets. In this case, the period for selling the property must correspond to the period for repaying the debt.
The balance sheet has absolute liquidity with the following ratio of assets and liabilities:
- A1 ≥ P1;
- A2 ≥ P2;
- A3 ≥ PZ;
- A4 ≤ P4.
The relationship of A1 and A2 with P1 and P2 determines the current liquidity, A3 and A4 with P3 and P4 - the predicted one. In this way, it is possible to plan the solvency of a company based on a comparison of upcoming revenues.
Product liquidity
The indicator reflects the ability of products to be quickly sold at an average price. For highly liquid goods, the sale period is 1 day, for medium liquid goods - up to several weeks, for low liquid goods - an indefinite period.
The indicator directly depends on the demand for products. The more in demand a product is among consumers, the higher its liquidity. If a manufacturer sells products quickly and often without losing profits, then it is highly liquid. Such goods, for example, include food, medicine, hygiene products, and alcoholic beverages.
ATTENTION!
However, the liquidity of products may change over time. A low indicator means that the product is less in demand in the current period.
The difference between profitability and solvency and liquidity
Many, even experienced businessmen, do not quite understand the difference between liquidity, solvency and profitability. Solvency is whether a firm has enough cash or equivalent assets to quickly pay off its accounts payable.
Liquidity is considered a broader concept, although closely related to solvency. The possibility of paying off debts for a specific period of time and determining the future state of settlements depends on it. This may be the liquidity of the company's general resources in case of bankruptcy and liquidation, or current assets that ensure solvency.
Profitability (profitability) is a relative indicator, which can also exist in case of illiquidity. For example, a small new company provides freight transportation services. Has three used cars and several employees on staff. The company took out a loan for its development and is considered low-liquidity, since its assets, when sold, will not cover its debts. If the company earns good daily revenue, then the net profit will be high. Therefore, the business is profitable. In the opposite case, a highly liquid company with low profitability can quickly become bankrupt.
How to assess the liquidity of an investment portfolio?
To assess the liquidity of an investment portfolio, it is necessary to analyze the indicator for all financial instruments included in it.
Analytics involves 2 parameters:
- time to convert investments into cash equivalent;
- the amount of investor losses during the transformation.
Based on the period of sale, financial instruments from the investment portfolio are classified into:
- Urgent highly liquid - the period of conversion into cash is up to 7 days.
- Highly liquid – the transformation period is 8–30 days.
- Medium-liquid - they are sold within 1–3 months.
- Low liquidity - the sale period is more than 3 months.
The assessment of portfolio liquidity is based on determining the shares of easily and difficultly sold investments in their total volume and the ratio of marketable and poorly marketable investments.
Lp = Ip / I, where:
- Lp is the share of highly liquid investments;
- Ip—quickly realized objects;
- I is the total volume of investment.
Lс = Iс / I, where:
- Lc is the share of low-liquid investments;
- Ic are difficult to implement objects.
Ki = Ip / Ic, where Ki is the ratio of realizable and weakly realizable investments.
With a significant share of well-realized investments in their total volume and a high ratio, the portfolio is considered liquid. Otherwise, the sale of individual financial instruments during market changes will be difficult.
ATTENTION!
When forming a portfolio, an investor is recommended to fill some of it with highly liquid securities. Despite the fact that such investments are predominantly low-yielding, they allow you to quickly respond to market changes.
Varieties
According to the degree of liquidity, assets are divided into three types:
- High. Highly liquid assets include: money in bank accounts, stocks and bonds, currency, government securities. Such funds can be converted very quickly.
- Average – accounts receivable (with the exception of short-term and bad debts) and products ready for sale. These assets can be converted into cash from 1 month to six months without a big loss in value.
- Low – overdue accounts receivable, outdated equipment and machinery, real estate. This category also includes savings that can be realized at a price close to the market price, but over a long period of time.
The same asset can be both highly liquid and low liquid. Examples:
- Oil corporation securities can be sold in a few seconds with very little difference to the purchase price. But shares of an unknown company will take much longer to sell and may lose up to a third of the original price;
- an elite suburban mansion will be classified as illiquid property due to its high cost, narrow circle of buyers, and the need for a personal car. In comparison, a sought-after three-room apartment in a big city can be sold much faster.
The more interest there is in an asset, the more liquid it will be. If a product is low-liquid, it means it is not in demand at the time.
In addition, there are other types of liquidity:
- current (short-term). It means the company’s ability to repay short-term obligations (up to 1 month) with highly liquid assets (cash and receivables);
- fast. Denotes the company’s ability to repay its obligations with highly liquid assets, goods and materials;
- instantaneous (absolute). Determines whether the company can pay its daily debt with available funds.
Liquidity analysis
When determining liquidity, the objects that have the highest indicators are initially assessed: money in the cash register, in accounts, deposits. What follows is an analysis of the securities of those companies that are well traded on stock exchanges.
Inventories of raw materials, materials, and the value of unfinished production have less liquidity. The determination of the indicator for the balance sheet is carried out according to the principle of its increase. The most important thing for analysis is the calculation of absolute, quick and current liquidity.
That is, liquidity is assessed:
- investments;
- assets.
For long-term investments, low- and medium-liquid assets are suitable: real estate, non-government bonds, shares. A 50/50 ratio of such assets is considered reliable. For aggressive investors (or exchange players), the recommended share of highly liquid objects is 80%. They are easy to sell without loss of value.
As for the internal assets of the enterprise, most of them are difficult to convert into money. Therefore, the analysis is aimed at tracking the amount of goods in circulation and money in accounts—highly liquid objects.
It is recommended to consider the acceptable standard for each enterprise separately. For example, if an organization uses minimal borrowed funds, purchasing materials for work does not require much cost, the liquidity limit can be reduced.
Concept
The concept of liquidity in economics is the provision of the sale of material resources for money at market value, and the degree of liquidity is the time required for this. This definition can be applied to various groups that have market value: balance sheet, savings, securities, business.
Assets include real estate, credit institutions, and companies. Liquidity is an important indicator for both businessmen and investors. For the former, this is a criterion for the normal proportion of free cash flows and the company’s liabilities, for the latter, it is a way to optimally invest investments.
Liquidity consists of the following:
- the solvency of the debtor, his ability to repay the debt within a certain period of time;
- the ability to obtain the greatest effect when exchanging goods and services for other goods or money (without loss in value);
- the ability of property to turn into money at a minimum cost and in a minimum period of time;
- market characteristics that reflect the speed and efficiency of transactions with the smallest difference in the cost of supply and demand;
- the ability of credit institutions to repay obligations on issued loans in accordance with their internal reserves;
- money;
- easy to implement.
Excess liquidity means that most of the capital is invested in bad projects. If a company does not pay its obligations, investors get rid of worthless assets. This leads to a drop in the price of these funds, as they try to sell them quickly before their price drops completely.
Limited liquidity is the opposite of excess liquidity. It means that:
- there is a lack of large available funds;
- assets are too expensive;
- interest rates are very high.
Factors affecting liquidity
In order for an organization to maintain its own liquidity, it is necessary to take into account the factors influencing it. It is important to have enough assets that have a high index. In addition to funds in accounts, quickly sold products, short-term financial investments, you need your own capital (authorized capital). It is advisable to diversify investments so that the price does not depend on the situation in specific markets.
Among the internal factors are the quality of management at the enterprise, the correctness of the organizational structure, image and reputation.
Ways to adjust the coefficient
Current liquidity tends to decrease, so you need to keep this indicator under control, increasing the value if necessary. In order to adjust the parameter, you first need to determine the reason for the decrease. Catalysts can be considered:
| Reasons for the decrease in equity capital | Reasons for increasing the liquidity ratio |
| Capital investments, the amount of which exceeds the amount of profit received, as well as long-term loans. | Restructuring loans or reducing the amount of company debts are other options. |
| Investments of resources obtained through short-term lending. | Increasing the volume of current assets. |
| Such reasons are common in situations where the current liquidity ratio decreases. | It is possible to carry out both of these procedures at the same time, but it is also possible to perform them separately. |
Factors influencing liquidity ratio
Ways to increase liquidity
Measures to improve the indicator should be aimed at improving asset quality:
- increase in working capital;
- profit growth;
- deleveraging;
- reduction of accounts receivable.
That is, to increase liquidity, a detailed analysis of it should be carried out in general for the enterprise and individual assets.
Liquidity assessment is necessary for both organizational leaders, investors and creditors. For business owners, the indicator reflects the effective ratio of free cash and liabilities of the enterprise. For investors and creditors, liquidity indicates the feasibility and required optimization of their investments.
How to increase liquidity
Effective working capital management
Optimization of indicators can occur by increasing the volume of cash, accounts receivable and inventories. It is important that these items grow rationally, based on the needs of the company. A thoughtless increase in working capital leads to an increase in coefficients when calculating liquidity, but does not indicate an improvement in the company's performance and can lead to the appearance of illiquid assets and losses.
Increase company profits
Profit growth increases equity capital, finances the purchase of assets and working capital. If a company has enough equity, it does not need to take out a lot of loans.
Reduce the share of accounts receivable
Accounts receivable can become “bad” if unscrupulous customers fail to pay their debts. But you can’t refuse it either—the introduction of prepayment can make the company less attractive. It is important to constantly monitor the size of accounts receivable and its share in current assets.
Dmitry Krasnoshchek, founder of legal:
“The specificity of our business is bankruptcy, and sometimes clients who find themselves in a difficult situation cannot pay on time. We pay more attention to the process of collecting receivables, carry out close control and constant monitoring. Otherwise, this is where the risk of loss of liquidity arises for us: if they don’t pay us, then we won’t be able to pay.”
Reduce or redistribute the credit load
Refinancing can allow a company to redistribute liabilities from current to long-term; this will have a positive effect on current liquidity, but a bad effect on the future. For the company in the example, this would be a good step - reducing current liabilities will increase current liquidity and increase net working capital. For this reason, it is also logical to extend the repayment of obligations over a longer period and attract long-term financing.
Accounting for financial capabilities in capital investments
If capital investments - the purchase of real estate and expensive equipment - are unjustified, they may lead to a loss of liquidity and an inability to pay loans. It is best if expensive investments are financed from accumulated profits or investments from the owners. Companies typically finance loan repayments using working capital, which leads to a decrease in net working capital and deterioration in liquidity.
