Liquidity and Value
Financial statements provide snapshot summaries of a company’s financial position. This snapshot is always from a historical perspective because even by the time the statements are published, market conditions and other factors have changed the value of the company. Liquidity is just another factor that affects the discrepancy between the book value and market value of a firm’s assets.
Liquidity refers to the ability of an asset to be sold quickly with minimal loss of value. Assets that are highly liquid, like short-term investments, can be bought and sold with relatively few transaction costs. Less liquid assets such as investments in plant and equipment command higher transaction costs making them less valuable. In other words, investment in plant and equipment are more difficult to turn into cash. Cash is considered the most liquid asset because it is the one asset that allows a company to realize its full value. Cash can be exchanged quickly and easily for any other asset. In fact, cash is so liquid, that it is generally considered to be liquidity itself within a one-currency economic system. Some problems do occur, however, when economic systems with different currencies interact. The threats and risk associated with currency exchanges do create some friction reducing the ability of an investor to assume that cash always a perfect measure of liquidity.
Liquidity of an asset can also be determined by its value to others. An automobile is useful to many other entities including individuals, small businesses, and corporations. However, a proprietary vehicle, one for transporting satellites, for example, is only useful to a few other entities. The ability to sell a satellite-transportation vehicle is much more difficult than a general-purpose car. Consequently, the book value of a vehicle doesn’t give any indication of the asset’s liquidity.
Were a company to find itself in financial distress, the ability to turn assets into cash quickly to cover current liabilities may mean the difference between survival and bankruptcy. All things being equal, a company with highly liquid assets is worth more than a company with less liquid assets because of the risk associated with being able to raise capital in times of economic hardship. The transaction costs of turning less liquid assets into cash may even put the company into a worse situation precluding the attempt to become liquid.
Wise investors know that asset liquidity is an important factor when valuing a company. Less liquid assets mean higher risk for stockholders and the price of stock will reflect this higher risk because of the Theory of Market Efficiency. Whenever an investor values a company’s assets, the historical perspective of the company’s financial statements must be understood to avoid incorrect valuation.