What is your Liquidity

 

There are many millionaires, billionaires and even everyday common people out there, who have made their money through liquidity? But what is liquidity? And how can a beginning layperson interested in obtaining true wealth, understand and use this term, while making it worthwhile for them? Hopefully, after reading this article, the art of obtaining wealth through liquidity, will become clearer and easier for you to understand.

What is liquidity?

It is something that allows an investor to buy and sell in the trading market without disturbing the price point. The best liquidity that can be used by investors is cash.

It is the most desirable for the investor and/or investment firm, because it offers the lowest risk for return. It is something that allows the investor to buy and sell easily and quickly as opposed to other assets. Cash is also seen as the greatest because you can buy anything, immediately. Basically liquidity is used to purchase products, services and other capital assets.

Liquidity Ratios

There are two liquidity ratios every investor needs to understand, the current ratio and the quick ratio.  The liquidity within a company and the vulnerability of the company depends upon the current ratio and the acid test or quick ratio.

The current ratio evaluates what a company is worth at the present moment based on its working capital. This means that the current assets of the company or products and/or services that are sold is divided by the company’s current liabilities or what the company is currently spending for buying, maintaining and distributing their products and services. The equation for a current ratio within a company is: current assets (products and services sold) divided by current liabilities (company spending).

The acid test or quick ratio is a ratio that looks at a company and evaluates its ability to pay off its short term debt. Does the company have the equity and/or funding or liquidity to pay off immediate debt quickly and efficiently? And is the supply greater than the demand? If the supply is greater than the demand,then the quick ratio or acid test, suggests that the company is not profiting or operating in the red, if the supply and demand from the consumer are equal, then the company is running in the black meaning revenue/assets and liabilities are the same and if the demand is greater than the supply, then the company will show profits and will be operating in the green.

Liquidity Traps

This happens during a recession where interest rates are at their lowest and banks are unwilling to lend due to fear of the drop in the markets and the economy favoring substantial financial loss. Also, the savings rates are at their highest, during this unstable time, making monetary policy ineffective for all involved.  The investor is unable to access capital at the most favorable rates.

A great example of this was a few years back, when the real estate market went through a difficult time.  Interest rates tanked.  At the same time less banks were giving out loans, because of the instability of the market and the inability of banks to trust the consumer and/or investor to repay the loans.

Liquidity Risks

As an investor it’s great to know what your net worth is.  Your net worth is not always the same as your liquid wealth.  This is where liquidity risks come in to play.  The risk is with the lack of liquidity as bigger assets can be challenging or just take longer to liquidate.  Such as, Real Estate which can be a great investment but can also turn on you.  Look at the real estate market in 2007.  That was a falling knife situation.  That means that you are trying to sell an asset that is decreasing in value very quickly.  It can be very hard to sell an asset in that hostile environment.  That is a perfect example of liquidity risk.

In the end, understanding and doing your research about any investment is always a good rule of thumb for anyone.  Having a basic understanding of liquidity, is key to making sound investments that will hopefully financially pay off for you.