‘Liquidity is an important metric to consider in the context of identifying a financially secure investment and then being able to trade that investment easily.’ Russell Pointon, director, consumer and media.

What is liquidity?

There are two types of liquidity in which investors should be interested. The first is the liquidity of the company’s shares and the second is the liquidity of the company’s underlying business.

Share liquidity refers to how easy it is for investors to buy and sell shares without affecting the share price. Higher or improved share liquidity should ensure that the share price reflects the company’s intrinsic value.

In this regard, not all shares are equal and can be split into different classes. For example, preferred or restricted shares usually have covenants dictating how and when they can be traded, meaning they are more challenging to divest and are considered ‘illiquid’ compared to ordinary shares. As a result, creating either preferred or restricted shares allows a company to limit liquidity.

In truth, the majority of companies prefer a higher level of share liquidity, rather than attempting to depress the trading of their shares.

How can share liquidity be determined?

Quantifying liquidity can be difficult as it varies with the volume of shares traded over time and due to other factors external to the company, such as general market sentiment.

The most useful indicators of liquidity are average daily traded volume and the bid-offer spread (the difference between the buying and selling prices of the company’s shares quoted on an exchange). Simply, the higher the average daily traded volume and the smaller the bid-offer spread, the better.

For example, assuming the same share price, a company whose shares have an average daily traded volume of 100,000 will have better liquidity than a company whose shares have an average daily traded volume of 10,000.

What is a company’s underlying liquidity?

A company’s underlying liquidity refers to its ability to meet its short-term financial obligations and commitments. This indicates the ease with which the company converts its short-term assets into cash to meet short-term liabilities with, preferably, a minimum of cost. As with share liquidity, an asset is not considered liquid if it cannot be sold quickly and at a discount to the recorded value in its financial statements.