What is liquidity? A comprehensive decoding for investors

What is liquidity? This article deciphers in detail the concept, assessment and importance of liquidity for businesses and investors.

Learn more about What is Liquidity?

So, what exactly? What is liquidity??

• Define: Liquidity Liquidity represents the ease and speed with which an asset can be converted into cash without significantly reducing its market value. At the corporate level, it reflects the ability to meet short-term financial obligations (less than 1 year) as they fall due with available current assets.
• Nature: Simply put, liquidity measures the immediate “solvency” of an individual, business, or a particular asset. Cash is considered the most liquid asset because it can be used immediately for transactions.
• Importance:
  • For Business: Ensuring continuity of operations, paying salaries, suppliers, short-term loans. Lack of liquidity can lead to crisis, even bankruptcy even if total assets are still large.
  • For Investors: Highly liquid assets (like blue-chip stocks) are easier to buy and sell, reducing the risk of not being able to exit a position when needed. Market liquidity also affects the bid-ask spread.
  • For the Economy: Liquidity in the banking system and financial markets is a key factor for economic stability and growth.

Distinguish between Liquidity and Solvency:

It is necessary to clearly distinguish between liquidity and solvency:

• Liquidity: Focus on ability to meet obligations short term. A company can have many long-term assets but still lack liquidity.
• Payment capacity: Refers to the ability to meet financial obligations long term. It looks at total assets versus total liabilities over the long term. A company can be liquid in the short term but insolvent in the long term if it has too much debt.

What is liquidity?

Clearly understand What is liquidity? is the first step to managing your finances effectively and making smart investment decisions.

Assessing the liquidity of the business

Job Assessing the liquidity of the business is an integral part of financial analysis, helping stakeholders (creditors, investors, management) understand the short-term financial health of the company. Why is this assessment important?

• For creditors: Assess credit risk, decide whether to grant short-term loans or not.
• For investors: Assess the business's operational stability and potential risks before investing.
• For Management: Identify strengths and weaknesses in cash flow management and propose timely improvement measures.

Factors affecting business liquidity:

• Business lines: Retail industries typically have faster cash cycles than heavy industry.
• Business cycle: Working capital needs and cash flows vary seasonally or with economic cycles.
• Management efficiency: The ability to manage inventory, receivables, and payables directly affects cash.
• Capital structure: High short-term debt ratios can put pressure on liquidity.
• Access to credit: Is it easy for businesses to borrow capital when needed?

Evaluation method:

Mainly based on analysis of financial statements (Balance Sheet, Income Statement, Cash Flow Statement) through:

1. Ratio analysis: Use the liquidity ratio (will be detailed later).
2. Cash flow analysis: Consider whether cash flow from operations is sufficient to cover short-term obligations.
3. Working capital analysis: Track changes in current assets and current liabilities.

Assessing the liquidity of the business requires careful consideration and a combination of methods to get the most comprehensive view.

Popular liquidity ratios

To quantify and liquidity assessment, financial analysts typically use a set of liquidity ratioThese ratios provide insight into the relationship between a company's current assets and current liabilities. Here are the most important ratios:

1. Current Ratio

This is the most basic and widely used index.

• Meaning: This ratio measures a company's ability to use short-term assets (cash, marketable securities, receivables, inventories) to pay short-term debts.
• Interpretation:
  • Ratio > 1: In theory, the business has enough short-term assets to pay short-term debts. Higher ratios (e.g. > 2) are generally considered safer.
  • Ratio < 1: Risk warning, the business may have difficulty paying due debts.
• Note: A ratio that is too high can also be bad, indicating that the business is not managing its assets effectively (too much unearned cash, large inventories). It should be compared with the industry average and the company's historical trends.
• For example: Company A has total current assets of 50 billion VND and total current liabilities of 25 billion VND. Current ratio = 50 / 25 = 2. This shows that for every 1 dong of current liabilities, the company has 2 dong of current assets ready to pay.

2. Quick Ratio / Acid-Test Ratio

This ratio is more stringent than the Current Ratio because it excludes inventories from current assets. Inventories are often considered the least liquid of the current assets.

• Meaning: Measures a company's ability to pay short-term debts with its more liquid assets (excluding inventories).
• Interpretation:
  • Ratio ≥ 1: Generally considered good, indicating that the business can pay short-term debts without having to sell inventory urgently.
  • Ratio < 1: Indicates dependence on inventory sales to pay debts, posing risks if sales are difficult.
• For example: Company A (example above) has Inventory of 15 billion VND. Quick ratio = (50 – 15) / 25 = 1.4. This ratio is still above 1, indicating a fairly good liquidity situation even without taking inventory into account.

3. Cash Ratio

This is the most conservative ratio, considering only cash and cash equivalents.

• Meaning: Measures the ability to pay short-term debts immediately using only cash and assets that can be converted to cash almost immediately.
• Interpretation:
  • There is no specific threshold, but this ratio indicates the highest level of cash safety. A ratio that is too high may indicate holding too much cash in an unproductive manner. A low ratio indicates a weak ability to withstand sudden financial shocks.
• For example: Company A has Cash and cash equivalents of 10 billion VND. Cash ratio = 10 / 25 = 0.4. This means that the company can only pay 40% of short-term debt immediately with available cash.

4. Cash Flow Liquidity Ratio

This ratio links liquidity to actual cash flows generated from core business operations, rather than just relying on assets/liabilities at a point in time on the balance sheet.

• Meaning: Measures the number of times a business's operating cash flow can cover its short-term liabilities. It reflects the ability to generate cash from core operations to meet debt obligations.
• Interpretation:
  • Ratio > 1: Shows that cash flow from operating activities is sufficient to pay short-term debt. The higher the ratio, the better.
  • Ratio < 1: Warns that core business operations are not generating enough cash to pay short-term debt, the company may have to rely on new debt or asset sales.
• Importance: Cash Flow Liquidity Ratio It is favored by many analysts because it focuses on actual cash flow – the lifeblood of a business – rather than accounting figures that can be affected by provisioning policies. It helps assess the quality of earnings and the sustainability of liquidity.

The combined use of liquidity ratio These and comparing them over multiple periods, against competitors and industry averages will provide a more complete and accurate picture of corporate liquidity.

Popular liquidity ratios

What are liquid assets?

As mentioned, What is liquidity? closely related to the speed at which assets are converted into cash. Therefore, highly liquid assets are assets that can be sold or converted into cash quickly, easily, and with the least loss of value.

Characteristics of highly liquid assets:

• Available Market: There are many potential buyers and sellers.
• Fast transaction: The buying and selling process is quick and does not take much time.
• Low price volatility: Property value is relatively stable, not reduced significantly when needing to sell urgently.
• Low transaction costs: Low brokerage fees, taxes or costs associated with conversion.

Examples of highly liquid assets (in descending order):

1. Cash: This is the most liquid asset, available for immediate use.
2. Cash Equivalents: Short-term, low-risk investments that are easily converted into cash within a very short period of time (usually less than 3 months), for example: treasury bills, short-term certificates of deposit.
3. Marketable Securities: Stocks and bonds listed on organized stock exchanges can be easily bought and sold during the trading day. Liquidity depends on trading volume and market depth for each specific code.
4. Accounts Receivable: Amounts owed to a business by customers. Although a current asset, collection can take time and there is a risk of non-recoverability (bad debt). Therefore, it is less liquid than cash and securities.
5. Inventory: Including raw materials, unfinished products, finished products. This is usually the least liquid asset in the group of current assets because it takes time to sell and the selling price can be affected by market demand, obsolescence, etc.

Understand about highly liquid assets helps businesses prioritize holding the right types of assets to ensure solvency, while helping investors recognize the company's financial flexibility.

Risks when a business loses liquidity

Insolvency is an extremely dangerous situation for any business. It is when a company no longer has enough cash or assets that can be easily converted into cash to meet short-term financial obligations that come due, such as paying employees, paying suppliers, or paying interest on bank loans.

Serious consequences of insolvency:

• Unable to pay debts due: This is the most obvious manifestation, leading to loss of reputation with suppliers and banks. Penalties and fees may arise, making the financial situation worse.
• Business interruption: Not having money to pay suppliers can lead to a stoppage of raw material supply. Not being able to pay salaries can cause employees to quit. Production and business activities are disrupted.
• Forced to sell assets at low prices: To get quick cash, businesses may have to sell important assets (including long-term assets) at prices much lower than their real value, causing huge losses.
• Loss of confidence from investors and creditors: When information about the insolvency spread, investors will sell stocks, creditors will tighten loan terms or refuse to lend more. Raising capital becomes extremely difficult.
• Risk of bankruptcy: This is the final and most serious consequence. If the liquidity problem cannot be resolved, the business may be forced to cease operations and enter bankruptcy proceedings.

Early warning signs of insolvency:

• The liquidity ratio (Current Ratio, Quick Ratio) continuously decreased over the periods.
• Cash flow from operating activities is negative or decreasing sharply.
• Over-reliance on short-term debt.
• Receivable turnover slows down, inventory turnover increases.
• Difficulty in accessing new sources of loans.

Recognize the signs early and understand the risks when insolvency It is very important for management to take timely preventive and corrective actions.

How to Improve Liquidity for Business

Maintain liquidity Soundness is an important financial management goal. When faced with the risk of shortage or wanting to increase stability, businesses can apply the following measures:

1. Working Capital Management:
   
   • Strictly manage receivables: Provide reasonable credit policies, closely monitor debts, and have effective debt collection measures (early payment discounts, periodic debt reminders).
   • Efficient inventory management: Apply advanced inventory management models (Just-in-Time), forecast demand accurately to avoid overstocking or shortage, liquidate slow-moving inventory.
   • Manage payables: Negotiate payment terms with suppliers (within reasonable limits so as not to affect reputation), take advantage of payment discount programs.
2. Cash Flow Management:
   
   • Detailed cash flow planning: Forecast short-term and medium-term income and expenses to proactively manage cash flow.
   • Speed up collection: Encourage customers to pay early, use fast electronic payment methods.
   • Control expenses: Review and cut unnecessary expenses, delay non-urgent investments if cash flow is tight.
3. Search for Funding Sources:
   
   • Bank credit line: Establish and maintain a backup credit line to use when you need cash quickly.
   • Short-term borrowing: Use short-term loans to finance seasonal working capital needs.
   • Issuing additional shares or bonds (longer term): If the liquidity problem is structural, recapitalization may be required.
4. Sell off unnecessary assets: Liquidate fixed assets that are no longer in use or non-core financial investments to generate cash.
   
5. Follow Market and Industry News: Always up to date Market News finance, interest rates, new regulations and industry trends to make adjustments to liquidity management strategies in line with the macroeconomic context and business environment. For example, when interest rates increase, the cost of borrowing will be higher, requiring businesses to manage cash more closely.

How to Improve Liquidity for Business

Flexible combination of the above solutions will help businesses improve and maintain liquidity, creating a solid foundation for stable operations and sustainable development.

Advice for Investors when analyzing liquidity

For investors, the liquidity assessment of a business before "putting down money" is the first step learn stock analysis can't be missed. Here are some helpful tips:

• Don't rely on just one metric: Each liquidity ratio has its own advantages and disadvantages. Consider Current Ratio, Quick Ratio, Cash Ratio and also cash flow liquidity ratio to have a multidimensional view.
• Compare to Industry Average and Competitors: Whether a liquidity ratio is high or low depends on the industry. Compare your company's ratio with that of other companies in the same industry and its direct competitors to assess its relative position.
• Trend Analysis over Time: Look at how liquidity ratios have changed over multiple quarters and years. Trends of improvement or deterioration are more important than a single number at a single point in time.
• Read the Notes to the Financial Statements carefully: This section typically provides more detailed information about the structure of current assets, current liabilities, working capital management policies and potential risks related to liquidity.
• Consider Qualitative Factors: Don’t just look at the numbers. Look at the quality of management, business strategy, competitive position, banking relationships… these factors also indirectly affect future liquidity.
• **Understand about highly liquid assets: Assess whether the company's current asset structure is truly "healthy" or overly dependent on unsaleable inventory or bad receivables.
• **Be alert for signs insolvency: If you notice a sudden deterioration in indicators and persistent negative cash flow, be cautious as this could be an early warning sign of risk.

By applying these tips, investors can make more in-depth assessments of a company's short-term financial health, thereby minimizing risk and increasing the chances of a successful investment.

Conclude

Through this detailed analysis, we hope you have a comprehensive and in-depth view of What is liquidity?. Together we have clarified the definition, its importance to both businesses and investors, and how to Assessing the liquidity of the business through the liquidity ratio popular as Current Ratio, Quick Ratio, Cash Ratio and especially cash flow liquidity ratio.

We have also identified the types of highly liquid assets and understand the serious risks when a business falls into a state of insolvencyFinally, suggestions on how to improve liquidity for businesses and advice for investors will be useful practical knowledge.Understanding and analyzing liquidity Not only is it the job of financial professionals, but it is also an essential skill for anyone who wants to manage their personal finances effectively or make smart investment decisions in the market. Always remember that cash flow and the ability to convert assets into cash is the lifeblood of every economic entity. Continue to equip yourself with knowledge and update financial information with HVA to make effective investment decisions.