What is liquidity? How it works and why it matters

At its core, liquidity is a measure of how quickly an asset can be bought or sold without significantly impacting its price. Put another way, liquidity reflects how readily an asset can be exchanged for money without losing value in the process.

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Cash itself is considered the most liquid asset because it can be used immediately to purchase goods or services. Other assets, like stocks, bonds, or real estate, must first be sold and converted into cash before they can be used.

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Liquidity exists on a spectrum. Highly liquid assets, such as stocks of large, well-known companies, can be bought and sold quickly and easily with minimal impact on price. On the other hand, illiquid assets, like rare artwork or private company shares, may take longer to sell and often require significant discounts to attract buyers.

How liquidity works

To better understand how liquidity works, let's consider an example. Imagine you own two assets: shares of Apple stock and a rare, vintage sports car. 

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If you needed to quickly raise cash, which asset would be easier to sell? Most likely, it would be the Apple stock. As a large, publicly-traded company, Apple has millions of shares outstanding, and there are always buyers and sellers in the market. You could sell your shares almost instantly at the current market price.

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Now, consider the vintage car. While it may be valuable, the pool of potential buyers is much smaller. It could take weeks or months to find the right buyer willing to pay a fair price. And if you needed to sell quickly, you might have to accept a lower price than the car is worth.

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In this example, the Apple stock is considered more liquid than the vintage car. The stock can be easily converted to cash, while the car requires more time and effort to sell.

How to measure liquidity

There are several ways to measure liquidity, depending on the context. For businesses, liquidity is often measured using financial ratios that compare a company's liquid assets to its short-term liabilities. Common ratios include:

1. Current ratio = Current assets / Current liabilities
2. Quick ratio (Acid-Test Ratio) = (Cash + Marketable securities + Accounts receivable) / Current liabilities
3. Cash ratio = Cash and cash equivalents / Current liabilities 

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For stocks, liquidity is often measured by trading volume and bid-ask spreads. Stocks with high trading volumes and narrow bid-ask spreads are considered more liquid, as there are many buyers and sellers in the market, and transactions can be executed quickly with minimal impact on price.

Why is liquidity important?

Liquidity is crucial for businesses, investors, and financial markets as a whole. For businesses, having sufficient liquidity ensures they can meet short-term obligations, such as paying bills, salaries, and taxes. Companies with poor liquidity may struggle to operate smoothly and could face financial distress or even bankruptcy.

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Investors also care about liquidity because it affects their ability to buy and sell assets quickly and at fair prices. Liquid markets, such as major stock exchanges, allow investors to easily enter and exit positions, which is essential for managing risk and seizing opportunities.

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Moreover, liquidity is important for the overall stability of financial markets. When markets are liquid, there is less volatility, and prices are more stable. Illiquid markets, on the other hand, can be prone to sudden price swings and market disruptions.

Types of liquidity

Liquidity can be measured in two main ways: market liquidity and accounting liquidity. These two types of liquidity provide valuable insights into the financial health and stability of assets, companies, and markets.

Market liquidity

This type of liquidity refers to the ease with which assets can be bought and sold in a particular market without significantly affecting the asset's price. In highly liquid markets, there are many buyers and sellers, and transactions can be executed quickly and efficiently. Liquid markets are characterized by tight bid-ask spreads (the difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to accept) and high trading volumes. Market liquidity is essential for investors, as it allows them to enter and exit positions easily and reduces the risk of being stuck with an illiquid asset.

Accounting liquidity

Accounting liquidity refers to a company's ability to meet its short-term financial obligations using its liquid assets. Liquid assets are those that can be easily converted into cash within a short period, such as cash, cash equivalents, and marketable securities. Financial ratios, such as the current ratio and the quick ratio, are used to assess a company's accounting liquidity. A higher ratio generally indicates better liquidity and a stronger ability to meet short-term obligations.

What is liquidity risk?

Liquidity risk is the danger that arises when an asset cannot be bought or sold quickly enough to prevent or minimize a loss. This risk is particularly relevant for investors holding illiquid assets, such as real estate, private company shares, or thinly-traded securities.

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For example, consider a real estate investor who owns several rental properties. If the investor suddenly needs cash to cover an unexpected expense, they may be forced to sell one of their properties at a discount due to the time it takes to find a buyer. This is an example of liquidity risk.

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Businesses also face liquidity risk when they hold assets that cannot be easily converted to cash. For instance, a company with a large inventory of unsold products may struggle to raise cash if sales decline unexpectedly.

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To manage liquidity risk, investors and businesses can employ various strategies, such as:

1. Diversifying their holdings across different asset classes and levels of liquidity
2. Maintaining a buffer of cash or highly liquid assets to cover unexpected expenses
3. Regularly monitoring liquidity ratios and adjusting as needed
4. Having access to lines of credit or other funding sources in case of emergency

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Liquidity in different markets

Liquidity plays a role in various financial markets, each with its own unique characteristics and challenges.

Stock market liquidity

In the stock market, liquidity is essential for efficient price discovery and smooth trading. Highly liquid stocks, such as those of large, well-known companies, can be easily bought and sold with minimal impact on price. These stocks typically have high trading volumes and narrow bid-ask spreads.

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On the other hand, less liquid stocks, such as those of small, lesser-known companies, may have lower trading volumes and wider bid-ask spreads. This can make it more difficult for investors to enter or exit positions without affecting the price.

Bond market liquidity

Liquidity in the bond market can vary depending on the type of bond and market conditions. Government bonds, especially those issued by major economies like the United States, are generally considered highly liquid due to their low default risk and active secondary market.

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Corporate bonds, on the other hand, can range from highly liquid (for large, well-known companies) to relatively illiquid (for smaller, less established firms). Bond market liquidity can also be affected by economic conditions, such as changes in interest rates or credit risk perceptions.

Real estate market liquidity

Real estate is often considered an illiquid asset class due to the time and costs involved in buying and selling properties. The liquidity of a particular property can depend on factors such as its location, property type, and market conditions.

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During economic downturns or financial crises, real estate market liquidity can dry up as buyers become scarce and financing becomes more difficult to obtain. This can lead to significant price discounts for sellers needing to raise cash quickly.

Forex market liquidity

The foreign exchange (forex) market is one of the most liquid financial markets in the world, with a daily trading volume of over $6 trillion. The high liquidity of the forex market is due to its global nature, 24-hour trading, and the participation of a wide range of players, including banks, corporations, and individual investors.

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However, not all currency pairs are equally liquid. Major currency pairs, such as EUR/USD or USD/JPY, typically have higher liquidity than less commonly traded pairs or those involving emerging market currencies.

Cryptocurrency market liquidity

Liquidity in the cryptocurrency market can vary significantly depending on the specific coin or token and the exchange platform. Bitcoin and Ethereum, the two largest cryptocurrencies by market capitalization, are generally considered the most liquid due to their high trading volumes and wide acceptance.

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However, smaller cryptocurrencies or those with limited trading pairs may have lower liquidity, resulting in wider bid-ask spreads and more significant price impact from individual trades. Additionally, the cryptocurrency market is known for its high volatility, which can further exacerbate liquidity risks.

Ramp: Improving your business liquidity

For businesses looking to improve their liquidity, Ramp offers a suite of financial tools and services designed to streamline expense management and optimize cash flow.

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With Ramp's corporate card and expense management platform, businesses can:

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• Set custom spend controls and limits to prevent overspending
• Automate expense reporting and reconciliation, saving time and reducing errors
• Gain real-time visibility into company-wide spending, enabling better decision-making
• Access higher credit limits and longer payment terms to improve short-term liquidity
• Earn cashback on purchases, providing an additional source of liquidity

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By leveraging Ramp's tools and insights, businesses can better manage their liquidity, freeing up cash for growth and investment opportunities. To learn more about how Ramp can help your business optimize its liquidity, sign up today.