Just like the scientific term, liquidity in finance has everything to do with “flow.”
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What Is Financial Liquidity?
In physics, liquidity refers to a substance’s ability to flow, which is a description that also works well in the stock market. Financial liquidity has everything to do with an asset’s ability to be transformed into another asset while maintaining its intrinsic value. Assets that are more difficult to sell are considered less liquid, or illiquid. The asset that is the most liquid, and thus the most easily transferrable, is cash. In fact, the fundamental meaning of “liquidate” is to convert something into cash.
One way to understand liquidity is to examine the level of difficulty at which a transaction can be completed. The easiest transactions, which are cash transactions, are also very liquid.
Take, for another example, selling tangible items on an online marketplace, like eBay. A t-shirt will most likely sell faster than a vintage bicycle, or a new car, or even a house, because those transactions are more complex—and more expensive. You wouldn’t pay for a car using t-shirts, would you? That transaction would be quite difficult to process. Instead, you would want to use cash.
A few examples of assets on the spectrum of liquidity. Cash is the most liquid while tangible assets, like real estate, are considered illiquid.
What Is Liquidity in the Stock Market?
Now let’s apply these concepts to the stock market. A stock is considered liquid when its shares can be bought—and sold—quickly with minimal impact to its market price. Large-cap companies traded on the major exchanges are considered to be liquid: They are traded in high volumes, and so the price per share a buyer makes (which is known as the bid) is very close to the price a seller will accept (known as the ask).
Smaller-cap companies, which are traded on smaller exchanges more infrequently than larger-cap companies, usually have higher liquidity risk. That means that the price per share a buyer offers could be very different than the price a seller will accept. This is known as a greater spread. When these kinds of stocks witness a surge in demand, they can also experience a lot of volatility.
Stock Liquidity Indicators
The simple rule of supply and demand helps to determine a stock’s liquidity. Stocks that are liquid have enough demand and supply of shares, which means that buy and sell transactions can happen smoothly.
Investors should take into consideration the stock’s bid-ask spread, which is the difference between the quoted price and its immediate purchase price. This is a fee paid by the buyer, and it represents an important part of the overall transaction cost.
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Just how much will an investor need to pay? There is no “average” bid-ask spread, but it’s good to note that there is a bias toward larger-cap stocks, which tend to have lower spreads than smaller cap stocks. Conceptually speaking, if your investment strategy included 100% turnover a year, meaning that you sold 100% of the stocks in your portfolio and replaced them with 100% new ones, if you incurred bid-ask spreads of just 50 basis points, that would mean you would have to pay 1% in trading costs alone! So be careful.
Volume is another indicator of liquidity. Higher trading volume means there is greater market interest for a particular stock, which makes for higher liquidity.
What Is Accounting Liquidity?
When characterizing liquidity, analysts aren’t merely examining what happens on the trading floors; rather, they are taking a deep look inside a company’s accounting practices, down to its balance sheet, so they can see how readily it can pay off its debts and other financial obligations—usually those that come due within a one-year timeframe—as well as seeing how much cash it has on hand. This is known as cash flow.
There are three ratios analysts use to measure a company’s liquidity.
- Current Ratio: this is calculated by taking the number of current assets and dividing it by the number of current liabilities. The total should be greater than 1, which signifies that the company’s assets are greater than its liabilities.
- Quick Ratio: this calculation is the sum of cash, accounts receivable, and equities divided by liabilities. It includes everything except inventories, because they are the most difficult to liquidate.
- Operating Cash Flow Ratio: this calculation is a measure of short-term liquidity and takes into consideration cash divided by liabilities. A high number here is better, as it signifies greater financial health (i.e., the company can cover its liabilities several times over).
Is Market Liquidity Good or Bad?
There’s only upside to market liquidity. In fact, the financial markets need liquidity to ensure that traders can open and close their positions efficiently and enjoy tighter bid-ask spreads. To put it simply, market liquidity actually lowers the cost of investing.
What Is the Illiquidity Premium?
As great as liquidity can be for the markets, there are some, particularly long-term, investment vehicles that benefit from a lack of liquidity. Pension plans and insurance companies look to capitalize on the risk premiums associated with illiquid assets like real estate, farmland, etc. that sport long-range maturations as well as offer incentives (i.e., interest) for their increased risk. This is known as an illiquidity premium.
What Are Some Real-Life Examples of Market Liquidity?
Banks play an important role in both accounting and market liquidity, for two main reasons:
- Banks lend cash to companies while holding their assets (as collateral), and
- They own both short- and long-term assets that can be converted into cash.
Liquidity is a process that banks must manage daily, and they are subject to requirements from the government that are intended to prevent a liquidity crisis. In fact, after the 2008 Financial Crisis, the Federal Deposit Insurance Corporation (FDIC) created a rule that required large banks to maintain a minimum level of short-term funding and thus reduce liquidity risk.
How Does the Fed Contribute to Market Liquidity?
In response to the COVID-19 crisis, in March 2020, the Federal Reserve began a series of fiscal stimuli by buying back trillions of dollars of U.S. Treasuries in an effort to increase market liquidity and avoid recession. This was known as quantitative easing. As inflation rose in 2021, the Fed announced that it would begin tapering its buybacks, and it increased interest rates in March, 2022. The entire world is waiting to see what will happen next.
