What is liquidity?

Liquidity is a concept that has made a lot of financial headlines in recent years. But what is liquidity, and why is it so important?

Liquidity is a concept that has made a lot of financial headlines in recent years, usually by springing nasty surprises on unsuspecting investors. For example, those who invested in Neil Woodford’s funds ran into trouble because his main fund held too many illiquid assets, leaving investors unable to withdraw their funds. And at various points over the last few years, investors in certain property funds have been left unable to withdraw their cash, again because the assets inside these funds are insufficiently liquid.

What is liquidity and why is it so important? 

Put simply, liquidity refers to how easy it is to buy or sell an asset without the price moving against you.

Cash is by far the most liquid asset, while physical assets such as collectables, property and art are considered to be illiquid. 

Why are some assets more liquid than others?

Property is illiquid because it takes a long time to buy or sell, trading costs are high, and you can never be certain of the price you’ll get until the deal is done. And if you want to sell in a hurry, you’ll have to cut your price to well below the theoretical “market value”. It’s a similar story for shares in unlisted companies – hence the problem with Woodford.

The Woodford debacle prompted the Investment Association, the trade body for investment trust managers, to propose a new type of fund to tackle the problem: a "long-term asset fund". This open-ended fund would own illiquid assets, but investors would only be allowed to withdraw their money at "appropriate time intervals", and would also have to pass some sort of "appropriateness tests".

Unlike property, shares in companies listed on the FTSE 100 are very liquid. You can get a price almost instantly, and you can almost always find a willing buyer or seller at that price. But in general broader equities and other financial instruments have different levels of liquidity. 

Bear in mind that the level of liquidity in a market is not fixed. It can vary widely. In times of turmoil it may even evaporate altogether, particularly in smaller markets. In the very worst panics, only the safest assets – such as US government bonds – may remain as liquid as they usually are.

Why can a lack of liquidity be bad?

A lack of liquidity is not in itself a problem. Indeed, illiquid assets usually deliver greater returns, precisely because of the lack of liquidity. The real problem arises when you are forced to sell an asset that you own which turns out to be far less liquid than you expected, just when you need to sell it.

For example an investor may be looking to sell a valuable work of art to fund the purchase of a car. In theory, the artwork could sell immediately; in reality it could take weeks, months or even years. So unless the seller of the car can afford to wait that long, the buyer may not be able to purchase the car. 

It’s another reminder to always understand exactly what you are investing in, before you invest in it. 

How do you measure liquidity?

There are three ways to measure liquidity. The current ratio is the most common measure of liquidity. It is calculated by dividing a company’s current assets by current liabilities. 

The acid-test ratio is another measure of liquidity. It subtracts inventories and pre-paid costs from current assets and divides the sum by current liabilities. 

The quick ratio factors higher liquidity assets. It is calculated by adding a company’s cash and cash equivalents, accounts payable and short-term investments and dividing by current liabilities. 

If a company’s assets perfectly match a company’s liabilities, then a company will have a liquidity ratio of one. A number less than one implies a company has insufficient cash to meet short-term financial commitments, while a figure of more than one implies a company has more than enough cash to meet short-term debt obligations.  

For more on the hidden risks to watch out for with illiquid assets, subscribe to MoneyWeek magazine.

SEE ALSO

• Remember Woodford, and make sure you can cash out

• Why on earth does anyone own open-ended property funds?

• What’s so special about investment trusts – and some of their dangers

 

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