The Definition of Liquidity in Finance | Small Business2 min read
The amount of cash a company has on hand or can generate quickly reveals how healthy the company is financially. High levels of available cash indicate that the business can pay off debt easily when due dates occur. The types of assets a company has and the marketability of those assets are where a discussion of financial liquidity begins.
Assets are any item or thing owned by a company and are broken into four categories: current, investment, intangible and property, plant and equipment. Current assets are cash, items that can be easily converted into cash or items that are expected to be used or gone within the fiscal year. Investment assets are stocks, bonds and other financial instruments that have a cash value. Intangible assets are things that have long-term value to the company such as patents, formulas and other proprietary information. Property, plant and equipment are long-term tangible assets needed for day-to-day operations.
Assets can be further categorized according to the degree of liquidity each asset has. Liquidity refers to the ability to convert the asset into cash — some items may be more liquid than others. For instance, a stock can be sold within minutes or days. However, property, such as land or buildings, can take weeks, months or even years to convert into cash. The ease with which financial instruments, such as stocks and bonds, are converted and ownership is transferred is why they are often referred to as liquid assets. However, most assets can eventually be exchanged for cash, or liquidated.
Marketability is another way of expressing the concept of liquidity. An asset’s liquidity, or marketability, requires an established marketplace with a large number of participants willing to purchase the asset. The asset must be desirable to the market participants. The less impact that selling the asset has on its price, meaning selling the asset does not constitute a financial loss for the company, the more liquid the asset is considered.
There is no official or standard formula from which to calculate general liquidity. However, financial formulas called ratios often are used to surmise whether the amount of debt owed can be paid by the company through liquidity. The “current ratio” can reveal whether the company has enough assets to generate the cash needed to pay off debt. This formula is written: current assets divided by current liabilities equals current ratio. A clearer picture about actual asset conversion can be seen using activity ratios, which indicate how quickly the company is liquidating current assets. Ratios that determine amounts of inventory turnover and the average collection period, or time it takes to liquidate inventory, are activity ratios that delve further into financial liquidity.