A lot of terms thrown around in the investing world are confusing for new investors—like liquidity. In this edition of the Arora Blog, we’ll be discussing its importance for investors, exploring how it impacts a successful exit, and giving tips for increasing liquidity.
If you’ve kept up on the Arora Blog, you’re already aware of the definition of liquidity. But in simple terms, liquidity refers to the ability of an asset to be converted into cash quickly and with minimal impact on the price of the asset.
But there are actually three types of liquidity that are important for investors to understand: share liquidity, investing liquidity, and liquidity of assets.
Share Liquidity
Share liquidity refers to the ability of shares in a company to be bought and sold quickly and easily on the stock market. When it comes to investments, share liquidity is important because it gives investors the flexibility to exit an investment if they need or want to.
For example, let’s say you invest in a company that isn’t performing well for your portfolio, and you need to sell your shares in order to avoid further losses. If the company’s shares are highly liquid, you should be able to sell them quickly and at a price that is not too far below the current market value. On the other hand, if the company’s shares are not liquid, it may take longer to find a buyer willing to pay a price that you’re happy with, or you may have to sell at a significant discount.
Investing Liquidity
Investing liquidity refers to the ability of an investor to exit an investment without having to sell their shares on the stock market.
If you invest in a startup company—like investments made through equity crowdfunding—you won’t be able to sell your shares until the company either launches an IPO, sells or is acquired, or some kind of secondary market is developed. That makes these shares extremely illiquid and difficult to sell if an investor needs or wants to.
For this reason, it’s important to carefully consider liquidity when making any investment decisions, but especially when investing via equity crowdfunding. It can have a larger-than-normal impact on the success of your portfolio.
Liquidity of Assets
When a company is looking to sell, the liquidity of its assets is a key factor in how successful the sale will be. This is also true on the consumer side of the equation, where the consumer owns both liquid and illiquid assets.
If asset liquidity is a spectrum, cash is the most liquid asset while things like real estate, collectibles, and private equity are among the most illiquid. Of course, this doesn’t mean that you will never receive cash for your illiquid assets—only that it can be more challenging to value assets like this and then find buyers willing to pay your asking price.
However, generally speaking, the more liquid assets are, the less their value will increase over time. For example, cash—the most liquid asset—will rarely ever increase in value, but can easily fall victim to inflation, causing you to have a gradual decrease in purchasing power over time while holding the same amount of money.
To protect against inflation and save for long-term financial goals, one of the best things a person or company can do is sacrifice some of their liquidity and make investments to grow wealth over time. This also makes a solid argument for diversifying your portfolio to include both liquid and illiquid assets to ensure a person or company can have the cash on hand they need to be financially stable in the long term.
Liquidity and Exits
Liquidity can have a big impact on the success of your investment, so it is important to keep it in mind when making investment decisions. If you are an investor investing in a company that you think has good prospects but poor liquidity, it may be worth considering waiting until the company’s situation improves before selling your shares. If your investing strategy involves the need to sell your shares quickly, you’re going to want to make sure that the company you are investing in has good share liquidity.
On the other hand, if you’re a company looking to navigate a successful exit, liquidity is important in other ways. If your illiquidity is negatively impacting your ability to launch an IPO or discouraging investors from acquiring your company, successfully exiting will be extremely difficult. At that point, it may be time to consider alternate ways of attaining cash on hand, including an equity crowdfunding raise (if you’re a private company), increasing the amount of shares your company has for sale on the stock market, increasing sales where possible, and cutting expenses where you can.
Measuring Liquidity
The most common way to measure liquidity is actually an extremely simple ratio calculation: current assets divided by current liabilities.
By looking at the ratio of your current assets to current liabilities, you’ll be able to gauge how much liquidity you have on hand. In general, the higher the ratio, the more liquidity you have, and vice versa.
In a period of economic stress, cash conversion cycles slow down; quick-selling assets become less quick. A business’s receivables take longer to collect, and inventory often takes longer to sell. Consumers take longer to pay off debts and tend to carry higher balances. Overall, this can decrease the ratio over time even with the same amount of assets and liabilities on the balance sheet.
Increasing Liquidity
Being weighed down by illiquid assets can seem like an untenable situation to be in when you need cash. But while it’s true that having a majority of your assets frozen can be scary, there are some relatively pain-free steps for consumers and companies alike to take that can free up some liquidity.
- Avoid Debt: Having to make fewer monthly payments that go towards debt is one of the easiest ways to ensure you always have liquid cash on hand.
- Save Your Pennies: We’re sure you’ve heard the widespread financial advice that you should always have a healthy savings account, but you should go a little further. Always have 3-6 months of savings that equal your most necessary monthly expenses in case of emergency.
- Limit Unnecessary Expenses: This one’s pretty simple! Don’t purchase things you don’t need and can’t afford—especially things that fall in value over time.
- Embody the Soul of a Bootstrapper: Bootstrapped companies are those that build without influxes of cash from outside sources. They tend to limit unnecessary expenses, pinch their pennies, and use creative solutions to stretch their money as far as it can go.
- Avoid Stockpiling: By only purchasing the things you need as you need them, and learning to accurately anticipate your needs, you can avoid sinking your cash into something that you could have waited to buy.
Ask the Experts
Here at Arora Project, we work every day with companies worried that their lack of liquidity will keep them from having a successful crowdfunding campaign. And while it might make your raise more difficult, it’s nothing we haven’t seen—and successfully navigated around—before.
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