Liquidity is a term that comes up often in conversations about portfolio management and business operations. If you’re working as a financial advisor or aspire to become one, understanding liquidity is necessary for helping your clients meet their goals and manage risks.
In this article, Wealth Professional Canada will highlight everything that you need to know about liquidity as well as how it works in different contexts. We’ll also talk about how you can measure and manage it for your clients.
Liquidity is the ease with which an asset can be converted into cash without losing value. In simple terms, it answers the question: how quickly can you or your clients access money if needed?
Assets that can be sold quickly and at a price close to their market value are considered liquid. Assets that take longer to sell, or require a price reduction to attract a buyer, are less liquid or even illiquid.
Think about selling a bike online. It’s usually quick and straightforward. Selling a car takes more time and effort. Selling a house can take even longer, with more steps and higher costs. The same idea applies to financial assets.
Stocks of blue-chip companies traded on major exchanges are highly liquid because they are bought and sold in large volumes every day. Shares of smaller companies, or assets like real estate, are less liquid because they don’t change hands as often and might require price adjustments to sell.
Watch this video to better understand how liquidity works:
Fixed income instruments can have different levels of liquidity depending on how easily they can be bought or sold in the market. Highly liquid fixed income instruments are easier to trade quickly at fair prices, while less liquid ones might be harder to sell without taking a loss.
Liquidity is important because it affects how easily one can access funds when needed. Suppose that your clients need to:
Having liquid assets allows them to do these things quickly, without selling investments at a loss. On the contrary, illiquid assets can tie up money and make it harder to respond to changing circumstances.
In financial markets, liquidity also helps keep prices stable. When there are many buyers and sellers, trades can happen quickly without causing big swings in prices. This stability is valuable for your clients, especially during periods of market volatility when emotions can run high.
Short answer: no. Liquidity and money are related, but they are not the same thing. Money, in the form of cash, is the most liquid asset. It can be used immediately for transactions. Other assets, like stocks or bonds, need to be sold before they can be turned into cash. The speed and ease of this process determine their liquidity.
For example, if your client wants to buy a new couch for $2,500, cash is the simplest way to pay. If your client has a collection of rare coins worth $2,500, they will need to find a buyer first. If the coins are in high demand, they are liquid. If not, your client might have to lower the price to sell them, making them less liquid.
In business, current assets like cash and marketable securities are considered highly liquid. Fixed assets like equipment or buildings are less liquid because they take longer to sell and are often required for business operations.
Mutual funds and exchange-traded funds (ETFs) are designed to let investors redeem their investments at any time, making them highly liquid. However, the liquidity of the fund’s underlying holdings is critical. If a fund invests in illiquid assets, it might struggle to meet redemption requests during periods of market stress. This can lead to losses for remaining investors.
Canadian securities regulations require investment fund managers to have procedures in place to manage liquidity risks. This includes considering how quickly each holding can be sold and monitoring redemption patterns.
As a financial advisor, it’s vital to review the liquidity of the funds your clients hold and understand how fund managers handle liquidity risks.
In the stock market, liquidity refers to how easily shares can be bought or sold without affecting their price. Stocks with large market caps, which are shares of big, well-known companies, are usually the most liquid. These stocks trade in high volumes every day. In turn, your clients can buy or sell shares quickly and at prices close to the market value.
Small-cap stocks, which are shares of smaller companies, are less liquid. They trade less frequently, so it can take longer to buy or sell them. Sudden changes in demand can cause bigger price swings, creating more risk for your clients.
There are two main ways to measure the liquidity of a stock: the bid-ask spread and trading volume. Let's discuss each below:
This is the difference between the highest price a buyer is willing to pay (the bid) and the lowest price a seller is willing to accept (the ask). A small spread means the stock is liquid.
For example, if the bid is $9 and the ask is $10, the spread is $1, or 10 percent of the ask price. Highly liquid stocks often have spreads of just a few cents.
This is the number of shares traded in a given period. High trading volume means it’s easy to buy or sell the stock at the market price. A daily trading volume of one million shares is generally a sign of good liquidity.
Liquidity comes in two main forms: market liquidity and accounting liquidity.
Both types of liquidity are valuable for your clients. Market liquidity affects how easily they can trade investments. Accounting liquidity affects the financial health of the companies they invest in.
The Liquidity Coverage Ratio (LCR) is a regulatory standard that requires banks to hold enough high-quality liquid assets to cover their total net cash outflows. This must be for 30 days during a financial stress scenario. The formula is high-quality liquid assets divided by net cash outflows over 30 days, and the ratio must be at least 100 percent.
The LCR is set and monitored by the Office of the Superintendent of Financial Institutions (OSFI) in line with Basel III standards.
Feel free to use our LCR calculator below:
There are several ratios you can use to measure a company’s accounting liquidity:
These ratios help you assess whether a company can cover its short-term debts and remain financially stable.
A good liquidity amount depends on the needs of your clients and the context of their investments. In general, having enough liquid assets to cover short-term obligations and unexpected expenses is important.
For companies, a current ratio of 1.5 or higher is often considered healthy. For your clients, the right amount of liquidity depends on their risk tolerance and time horizon. Their financial goals must also be considered.
It’s also useful to compare liquidity ratios to industry benchmarks. For example, if a company’s current ratio is two and the industry average is 1.5, the company has a strong liquidity position. If the industry average is two and the company’s ratio is one, there might be cause for concern.
Liquidity is not just about having cash on hand. It’s about having the flexibility to respond to opportunities and challenges without being forced to sell assets at a loss.
Here are three ways companies improve their liquidity, and how your clients can benefit:
Businesses that track their liquidity ratios regularly are better positioned to avoid cash flow problems. Your clients can look for companies that report healthy liquidity ratios as potential investments.
Companies that use liquidity as part of their strategic planning are more likely to achieve sustainable growth. When a business sets clear goals and monitors liquidity, it can allocate resources effectively. Your clients might find opportunities in businesses that demonstrate disciplined liquidity management.
Paying down short-term debts improves a company’s liquidity position. Businesses that manage their liabilities carefully are less likely to face financial stress. Your clients might prefer companies that show a commitment to reducing debt.
Managing liquidity is not just about avoiding problems. It’s also about positioning your clients to take advantage of opportunities as they arise. Check out this video to help your clients spot improved market liquidity:
Liquidity is a fundamental concept for both financial advisors and investors. It affects how easily your clients can access their money to manage risks and pursue new opportunities. Whether you are looking at market liquidity for investments or accounting liquidity for businesses, managing liquidity is key to supporting your clients’ financial well-being.
Measuring liquidity and planning with liquidity in mind can help you guide your clients toward financial stability and growth. The same is true for benchmarking against industry standards.
Liquidity is not just a technical metric—it’s a useful principle for building resilient portfolios and businesses that can weather challenges and seize opportunities.
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