Liquidity is a common concept in financial markets and cryptocurrencies. In its simplest definition, liquidity is the process of converting an asset into cash easily and quickly without interfering with its price. Cash is considered the most liquid asset. Because it is easier and faster to convert cash into other assets. Liquidity allows assets to be bought and sold quickly and easily. If there is poor or low liquidity in the market, it takes longer and is more difficult to buy and sell an asset. If a trade is executed in such a situation, poor or low liquidity will have a significant impact on the price of the trade.

Thanks to liquidity, buyers and sellers are quickly matched on cryptocurrency platforms that have a lot of transactions, high trading volumes and a large number of traders. Traders prefer liquid markets. In liquid markets, traders can buy and sell their assets in a short period of time and without much fluctuation in price. There are two types of liquidity: Accounting liquidity and market liquidity.

What Is Accounting Liquidity?

Accounting liquidity refers to the ability of individuals or companies to meet their financial responsibilities with liquid assets. Accounting liquidity is very important for the financial health of individuals and businesses. It refers to the ease with which short-term debts and necessary liabilities can be paid with liquid assets. Analysts and investors use some ratios to measure accounting liquidity and identify companies with strong liquidity. These ratios are cash ratio, acid test ratio and current ratio.

What Is Market Liquidity?

Market liquidity refers to markets where two assets can be exchanged with a narrow bid-ask spread and transparent pricing. Pricing is as close as possible to the intrinsic value of the asset and therefore prices are fair in liquid markets. The higher the volume of a business or exchange, the higher the liquidity ratio. Liquid markets are platforms where assets can be quickly and easily converted into cash. This is why traders prefer liquid markets to exchange their assets efficiently.

How to Measure Liquidity?

Financial analysts and investors use some ratios to measure the liquidity of a business and stock market. These ratios fall into three groups: current ratio, acid test ratio and cash ratio.

1.Current Ratio

The ratio of current assets (that can be reasonably converted into cash within one year) divided by short-term liabilities is called the current ratio. A current ratio of 2, which measures whether an entity can continue in business with its net capital, is generally sufficient to meet its obligations. If a company's current ratio is more than 1, it means that the company can pay its debts with its net capital.

2.Acid Test Ratio

The acid test ratio is not used to calculate the situation of businesses with low liquidity. And it consists of more detailed calculations than the current ratio. Current assets, inventories and current liabilities are taken into consideration when calculating the acid test ratio. Then the remaining figure is divided by the short-term liabilities to arrive at the acid test ratio.

3.Cash Ratio

The cash ratio is used to determine a company's ability to collect its receivables and payables in a worst-case scenario and to fulfill its obligations in the event of a trading halt. The cash ratio measures the ability of companies to have the liquidity to withstand incalculable events in order to avoid problems. First, receivables and inventories are subtracted from current assets. Then the amount of cash obtained is divided by short-term liabilities to obtain the cash ratio. In order to maintain liquidity, a company should have a cash ratio between 0.20 and 1.

Why Liquidity Is Important for Market and Investors?

In illiquid markets, it takes longer and becomes more difficult for individuals and companies to convert their assets into cash. Illiquid assets that need to be sold in the short term are often sold for less than they are worth. The spread between the two assets grows and pricing loses transparency. Therefore, traders cannot use their assets efficiently. In addition, a company must have the liquidity to survive and fulfill its financial obligations. Otherwise, companies without liquidity may face situations that may lead to bankruptcy. Liquidity allows investors to trade at the price they demand. In liquid markets, it is easier for buyers and sellers to match. Thanks to the convenience, price and speed provided by liquidity, individuals or companies can realize their investments efficiently and fulfill their financial obligations.

What Is Liquidity in Cryptocurrency?

In the cryptocurrency market, liquidity refers to the ability to convert a digital currency or token into cash or other digital assets without a change in its price. Investors and traders interested in crypto prefer liquid crypto markets. Liquidity in cryptocurrency reduces investors' investment risk and makes it easier for them to sell their holdings. In this sense, liquidity is a helpful element in creating an investment strategy for individuals.

Examples of Liquidity

According to the research, as of April 16, 2019, the average daily trading volume of Forex (Foreign Exchange) was 6 trillion dollars. Forex, which provides the opportunity to trade 24 hours a day, 5 days a week, is one of the most well-known markets in terms of liquidity.

Bitcoin is also one of the liquid cryptocurrency. Despite experiencing declines due to a lack of liquidity, Bitcoin's daily trading volume increased back above $15 billion in early 2020. The continuity of trading and the increase in volume led to an increase in liquidity.

What Is Liquidity Crisis?

A liquidity crisis refers to a situation in which businesses or governments borrow on credit and experience a decline in liquidity when debts are not repaid. When financial liabilities are not paid, there is a reduction in the use of cash. Companies facing a liquidity crisis face a decline in the value of their assets and a decrease in the rate at which these assets are converted into cash due to a lack of liquidity. If borrowing cannot be prevented, a banking crisis may also occur. A liquidity crisis usually affects more than one institution and the entire financial system at the same time.