In finance, liquidity takes one of two forms based on the definition of liquidity. One type of liquidity refers to the ability to trade an asset, such as a stock or bond, at its current price.
Investors still use liquidity ratios to evaluate the value of a company’s stocks or bonds, but they also care about a different kind of liquidity management. Those who trade assets on the stock market can’t just buy or sell any asset at any time; the buyers need a seller, and the sellers need a buyer.
When a buyer cannot find a seller at the current price, he or she must usually raise his or her bid to entice someone to part with the asset. The opposite is true for sellers, who must reduce their ask prices to entice buyers. Assets that cannot be exchanged at a current price are considered illiquid.
The other definition of liquidity applies to large organisations, such as financial institutions. Banks are often evaluated on their liquidity, or their ability to meet cash and collateral obligations without incurring substantial losses.
In either case, liquidity describes the effort of investors or managers to reduce liquidity risk exposure. All companies and governments that have debt obligations face liquidity risk. Investors, lenders and managers all look to a company’s financial statements, using liquidity measurement ratios to evaluate liquidity risk.
This is usually done by comparing liquid assets and short-term liabilities. Companies that are over-leveraged must take steps to reduce the gap between their cash on hand and their debt obligations. Investors and traders manage liquidity risk by not leaving too much of their portfolios in illiquid markets.
And it’s the liquidity of major banks that’s especially scrutinised. These organisations are subjected to heavy regulation and stress tests to assess their liquidity management because they’re considered economically vital institutions. Here, liquidity risk management uses accounting techniques to assess the need for cash or collateral to meet financial obligations.