The two things you need to check about liquidity before you invest

Julie Brownlee, Fsp Invest, 30 Sep. 2014

Tags: liquidity, what is liquidity, company liquidity, share liquidity, investing,

Liquidity is an important aspect to consider when investing for two main reasons.

Firstly, you want to look at how liquid a company is. Secondly, you want to know how liquid a company’s shares are before you invest.

So how can you do this?

Let’s take a closer look…

How to check a company’s liquidity

The liquidity of a company shows how quickly it can turn assets into cash so it can pay its bills.

So how can you measure a company’s liquidity?

You can use the current ratio. This financial ratio compares a company’s current assets with its current liabilities.

Current assets include cash, trade debtors (sales on credit) and stocks. Current liabilities include borrowings, tax and supplier invoices.

To get these figures, you just need to look at a company’s balance sheet in its most recent set of accounts.

Let’s have a look at an example…

Company ABC has current assets of R200 million. It has current liabilities of R100 million. This gives it a current ratio of 2 (R200 million/R100 million).

A current ratio of 2 suggests the company isn’t in danger of meeting its liabilities. If the current ratio dips below 1, it may suggest that trouble is brewing within the company.

But it’s not always the case. It all comes down to how quickly a company can turn assets into cash.

For instance, supermarkets tend to have current ratios of below one. Yet they can turn their goods into cash within days, but they have 30 days or more to pay their suppliers back.

The liquidity of a company’s shares

When you’re investing in shares, you should check out a company’s liquidity before buying.

If you’re buying shares in a large company, chances are the shares will be very liquid. This means you’ll have no trouble selling your shares should you want to. Hundreds of thousands of shares may change hands daily.

On the other hand, if the shares are in a small company, the shares might not be very liquid. There may be days that there isn’t any trade in the shares at all.

This means if you buy shares in a company like this, it might take a while to sell your shares. And the spread (the difference between the buying and selling price) may be large.

So there you have it, the two things you need to know about liquidity.

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