What is liquidity? How easily you can sell an asset for cash — here’s when and why it matters to your finances


Summary List Placement

Liquidity may take on a different meaning depending on the context, but it always has to do with one thing: cash, or ready money. 

Liquidity refers to the amount of money that is promptly available to meet debts or to use for investment. It indicates the levels of cash available and how quickly a financial asset or security can be converted into cash without losing significant value. In other words, how long it takes to sell. 

Liquidity is important because it shows how flexible a company is in meeting its financial obligations and unexpected costs. It also applies to the average individual as well. The greater their liquid assets (cash savings and investment portfolio) compared to their debts, the better their financial situation.

Types of liquidity

Liquidity comes in two basic forms: market liquidity, which applies to investments and assets, and accounting liquidity, which applies to corporate or personal finances.

Market liquidity

Market liquidity refers to the liquidity of an asset and how quickly it can be turned into cash. In effect, how marketable it is, at prices that are stable and transparent. 

High market liquidity means that there is a high supply and a high demand for an asset and that there will always be sellers and buyers for that asset. If someone wants to sell an asset yet there is no one to buy it, then it cannot be liquid. 

Liquidity is not the same thing as profitability. Shares of a publicly traded company, for example, are liquid: They can be sold quickly on a stock exchange, even if they have dropped in value. There will always be someone to buy them. 

When investing, it is important for an investor to bear in mind the liquidity of a particular asset or security. Among investments and financial vehicles, the most liquid assets include:

Savings/money market accounts

Stocks traded on major exchanges and exchange-traded funds
US government bonds
Commercial paper
Other short-term money-market securities

These all can be sold quickly at their fair value in return for cash. 

Examples of illiquid assets, or those that can not be converted to cash quickly, tend to be tangible things, like real estate and fine art. They also include securities that trade on foreign stock exchanges, or penny stocks, which trade over the counter. 

These items all take a long time to sell.

Accounting liquidity

Accounting liquidity refers to a company’s or a person’s ability to meet their financial obligations — aka the money they owe on an ongoing basis. 

With individuals, figuring liquidity is a matter of comparing their debts to the amount of cash they have in the bank or the marketable securities in their investment accounts. 

With companies, it gets a tad more complex. Liquidity takes a look at a company’s current assets versus its current liabilities.

Why liquidity is important

The higher their liquidity, the better the financial health of a business or a person is. 

For example, say a company had a monthly loan payment of $5,000. Its sales are doing well and the company is realizing profits. It has no …read more

Source:: Business Insider


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