Liquidity describes a business or person’s ability to easily convert assets into cash to spend or invest as needed. Cash itself is naturally the most liquid of assets, as it’s immediately ready for use and can be disposed of at its market value in exchange for other assets.
Types of asset that could be liquidated includes anything that provides a current, future, or potential economic benefit, such as stock, retail inventory, property, and investments.
Key takeaways from this section:
- Liquidity represents how easy it is to convert an asset at its market value.
- Cash is the most liquid asset as it can be easily and quickly used to obtain other assets.
- Strong liquidity is important for a market or business so goods can be converted without losing their value.
Liquidity represents a measure of how easily something can be used for its market value, ie bought or sold. Different assets have different levels of liquidity, affecting a person or organisation’s ability to make use of those assets.
Cash represents the highest level of liquidity because it can easily be converted into other assets. Other financial assets such as shares or equities may fall further down on the scale of liquidity, but could still be considered as relatively liquid compared to tangible, or physical, assets.
A tangible asset includes items such as property, land, antiques, or fine art, and these are seen as much less liquid as they are harder to quickly convert into cash at their market value.
There are also different types of financial liquidity, including market liquidity and accounting liquidity.
Market liquidity refers to the ability of a company or individual to sell an asset at the market price, ie without drastically changing its value. A liquid market allows assets to be sold and bought relatively easily without any major loss of value. In an illiquid market, assets may have to be heavily discounted and lose their value in order to sell them in a reasonable amount of time.
Accounting liquidity measures the ability of an individual or business to make use of their assets to cover financial obligations such as debts. If a company has illiquid assets that may have to be sold for less than their market value, then they would be considered a business with weak liquidity.
How to calculate liquidity
There are several ways liquidity can be analysed using financial ratios and equations, including the current ratio, which simply measures current assets against current liabilities, or the cash ratio, which only defines liquid assets as ready cash.
Liquidity in practice
If a person wanted to purchase an expensive item, such as a car that cost £12,000, having the cash in the bank would be the most easily available and liquid asset to use to purchase it. They might have other valuable assets such as antiques or fine art, but naturally a salesperson is highly unlikely to accept such items at their market value to pay for the car. If they wanted to liquidate those assets to fund the purchase, it could take a long time to find a buyer willing to pay an acceptable price, which would delay buying the car by quite some time compared to having the cash ready in the bank.
What does liquidity mean in business?
Liquidity measures a company’s ability to convert their assets into cash to cover financial obligations. Assets could include ready cash as well as retail stock or property, with different types of assets more easily liquidated than others.
Is high liquidity good?
Measuring liquidity with a current or cash ratio can give a basic indication of financial health, and a rating over 1.0 means a business should be less likely to run into financial difficulties. However, this can vary across different types of businesses and with different industry norms.
What are the most liquid assets?
The most liquid asset is cash, followed by any asset that can be quickly turned into cash such as stocks and bonds. Anything that can be easily converted to cash within the financial year would also be considered a liquid asset.
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