Investors often fail to take into account liquidity when making their financial decisions. It’s an important aspect of any portfolio and managing it is key to a successful investment. The fact is, financial liquidity or a lack thereof can make or break your financial decisions. Many lose money because they lack cash in critical moments where they could have made proper investment decisions, while others fail to create any meaningful profits in short term investments. Understanding liquidity is crucial for successful investments.
1. What is liquidity?
From a strictly financial perspective, liquidity refers to your ability to access a specific investment or asset. If you’re wondering how to measure the liquidity of an asset, you just need to ask yourself how long it would take to turn it into cold, hard cash. The quicker you can use that money, the higher the liquidity of the investment.
For example, funds in a retirement account aren’t exactly liquid. To redeem them, you have to fill out quite a bit of paperwork and wait some time until you get the money in the mail. By the time you have it in your hands, a lot of time has already passed.
2. Understand how the term came to be
Liquidity doesn’t always mean the same thing. The definition has changed over time and it has come to include many different factors of an asset. Take, for example, the volatility of an investment. You can make a proper investment into a short-term asset that is easy to turn into cash, which means you have made an investment into a liquid asset.
When you take into account the volatility of the asset, the long-term implications are also calculated. You could have invested that money into a long-term asset instead, in order for it to grow over time. Removing money from a liquid asset too quickly could lead to a loss of money. Volatility isn’t considered a part of liquidity today, but it might explain why some investors could have differing definitions of volatile for some assets.
3. Importance of liquidity
Most people learn about liquidity and see it as the holy grail of business. Obviously, you want to have assets that you can turn into cash in the blink of an eye. However, keep in mind that liquidity isn’t necessarily the magic word some make it out to be. There’s nothing wrong with keeping illiquid assets into your possession. In fact, they’re considered a hallmark of a healthy financial portfolio.
In order to properly invest in any kind of market, you’re going to want a healthy combination of both liquid and illiquid assets. This allows you to make long-term financial decisions while also having a lot of cash on hand to invest when something pops up. Look at real estate, for example. It’s considered a very illiquid asset, but everyone wants to get in on the market. It might not turn into cash any time soon, but it will accrue value over time, which is why it’s considered a good investment.
Sometimes, liquidity can be hidden behind company rules. If you’re buying stocks in a publicly traded company, selling the shares is as simple as contacting your broker. On the other hand, private companies are a bit different in this regard. They have rules in place that might delay your ability to sell stocks. You could be hedged by some rules if you try to liquidate those assets. On the other hand, what if nobody wants to purchase stocks in this private company?
4. Financial liquidity
Cash is the most liquid financial asset that you can possess. You want to turn all of your other investments and assets into cash on demand. Stocks and bonds are great examples of assets that can be quickly transformed into cash. Because of this, they are considered very liquid investments.
Collectibles are assets that are less liquid than bonds and stocks, but they are still somewhat easy to sell. In this scenario, liquidity also refers to the price you’re able to sell them for. Coins, stamps, and art are only worth what someone else is willing to pay for them. The right collector might pay the full price, but it could take a while to find them. On the other hand, you could sell these items for a lower price to pawn shops if you need the money in a hurry.
Assets like diamonds are considered somewhere in the middle. They are pretty liquid in terms of where and how you can sell them. Just about every market in the world has buyers and their prices remain stable. If an investor tried to turn part of their diamond portfolio into cash, it would take them a couple of weeks to find the right buyer and it would require some help from a middleman. This why a lot of newer investors might need a bit of help with selling diamonds, especially if they haven’t got the necessary connections.
Assets like land and real estate are considered the least liquid assets. They might be worth a lot, but selling them could take you weeks or months.
When you want to invest money into an asset, you need to take into account its liquidity before you make any crucial steps. It could be difficult to turn it back into cash if it’s not a liquid asset. However, selling an asset isn’t the only way to obtain cash. Borrowing against it is also an option. Banks use this when they lend money to businesses. The companies’ assets are used as collateral for a loan, which allows them to give cash to the business. The assets the company vouches for aren’t necessarily liquid, but the bank treats them as such.
5. Liquidity and businesses
The liquidity of a company usually has a different meaning to classical liquidity. It typically refers to the ability of a company to use current assets to pay off short-term liabilities. Another factor measured in its liquidity is the amount of cash that is generated above its liabilities. This cash is often used to expand the business and pay shareholders via dividends. This aspect of doing business is called cash flow. In a way, having a lot of cash flow is how you define the liquidity of a company.
However, there are other elements that come into play within its liquidity. There are some more common ratios that are also used in the assessment. The current ratio is calculated by dividing the company’s current assets by the company’s current liabilities and debts. It’s called current because it refers to short-term assets and liabilities. Industry standards tend to vary, but the ideal ratio you would have in any given year would be a ratio of one. The so-called “acid test” ratio is no different from the current ratio, except that it doesn’t take into account inventory. This is excluded because inventory is the most difficult asset to quickly turn into cash. Compared to short-term investments, accounts receivable, and cash, inventory is illiquid.
Operating cash flow ratio measures how well the company covering its current liabilities with generated cash flow from operations. You can look at it as the number of times the company can pay off its current debts from cash generated in the same period. Increased cash flow is a sign of a healthy business.
Without a proper understanding of liquidity, an investor can’t make sound financial decisions regarding their portfolio. The ability to quickly get funds in your account is crucial for short term financing and planning new investments. Knowing when to set aside money for long-term investments is just as important. The difference between an experienced investor and a newbie is the number of diverse investments in their portfolio. This includes diversity in terms of liquid and illiquid assets. Investing has always been a complicated and volatile business, but with proper knowledge of liquidity and how to manage it, you can easily make sound financial decisions that will lead to profits in the long term.