What Is Liquidity?

What Is Liquidity?

What exactly is liquidity? The concept of liquidity is simply how easily something can be sold for cash while retaining most of its market value. Things that might be sold range from assets to securities that might be converted into cash.

In terms of raw liquidity, cash is the most liquid asset that exists in the current economy. Tangible items of a physical nature aren't as liquid. While there are many kinds of liquidity, two common categories include accounting liquidity and market liquidity.

How to Understand Liquidity

What Is Liquidity?

Liquidity can apply to companies and private individuals. In your own case, liquidity would be how fast or easily you could buy or sell an asset at a price point that represents its relative value. Cash is the most liquid of all assets considering how fast and easy you can use it to buy other assets.

Tangible assets are things that aren't very liquid at all. These are things you might own such as collectibles, fine art, and real estate. It's always possible to sell them, but it might take some time and you might have trouble getting close to full value for them.

Many financial assets wind up having different spots on the liquidity spectrum. Anything from partnership units to equities has its own unique challenges in terms of buying and selling. Certain financial assets, especially equities such as stocks, might have market values that fluctuate continuously.

An Example:

Consider a hypothetical situation where you want a big-screen TV that costs $500. Cash is the easiest asset you could use to buy it. However, assuming you don't have enough cash, you do have a collection of collectible baseball cards valued at $500.

What are the chances you'd find someone with a $500 television that wants your baseball cards and would just trade with you? The odds of that happening aren't in your favor unless you look for a very long time. It's probably not even worth it.

The more likely move you have to make is selling your collection so you can use that cash to get your TV. If you have time to wait things out, that might work. Selling a collection of rare items for full value might take a while.

What if the TV you want is only on sale for a few days? What if you want it for a sports game coming up this weekend? Time isn't on your side anymore.

You might have to sell the collectible baseball cards to a local sports memorabilia shop at a discount instead of through an auction. They're still an asset you convert to cash, but you don't get as much. This makes them an illiquid asset.

Two Primary Measures

What Is Liquidity?

There are many ways that you can measure liquidity. One of them is called accounting liquidity. The other kind is known as market liquidity.

Accounting Liquidity

Accounting liquidity talks about how easily a person or business might handle their financial commitments with the resources they have on hand. That's mainly what liquid assets that have available. How much capacity do they have to pay debts when they are due?

On the TV for baseball cards example, the sports cards aren't very liquid. It's unlikely that they'd net their full $500 value in a quick transaction. When talking about investments, determining accounting liquidity involves a comparison of liquid assets to any current liabilities, such as financial obligations that will happen within the next 12 months.

Several different ratios are useful in measuring accounting liquidity. They vary in how liquid assets are even defined. Investors and analysts alike apply these ratios to ascertain which businesses have strong liquidity or not.

Market Liquidity

This kind of liquidity refers to how much a particular market might let assets be purchased or sold at transparent and stable prices. Specific markets might be the stock market of the entire nation or the real estate market in a certain city. In the aforementioned example, the market for TVs exchanged for collectible baseball cards proves so very illiquid that it really doesn't exist.

Alternatively, stock markets, such as the Dow Jones or NASDAQ, have considerably more market liquidity. Exchanges with high trading volumes not dominated by selling have prices fairly close to one another. This would be where bid prices, which buyers offer for shares, closely match asking prices, which are what sellers will accept.

In cases like these, investors don't have to give up much of anything and can still make a quick sale. The difference between ask and bid prices is called the spread. When it tightens, the market is increasingly liquid.

However, if the spread grows, then the market gets to be more illiquid in nature. Real estate markets are often not very liquid compared to stock markets. Other asset markets with similarly variable states of liquidity include commodities, currencies, contracts, and derivatives.

Why Does Liquidity Matter?

What Is Liquidity?

When markets aren't very liquid, then it's harder to convert or sell securities, assets, and possessions for cash. If you happen to own a rare family heirloom worth a lot more than those baseball cards talked about earlier, but you can't find buyers, then it's very illiquid. You might need an auction house to possibly find interested buyers, and the auction broker will charge a commission.

Liquid assets are things that you can sell quickly and easily. You should get close to their full value for them. Also, selling them shouldn't cost much.

A company that doesn't maintain sufficient liquid assets might have trouble paying its staff wages or the bills that come due from various expenses. A liquidity crisis results. That can quickly turn into a bankruptcy situation.

What Is Stock Liquidity

Stock liquidity is a measurement of how efficiently you might buy or sell shares. You can assess a stock's liquidity by seeing its average trading volume. That represents the number of shares changing hands on a certain day.

What Is Cryptocurrency Liquidity?

In the realm of digital currencies, liquidity is a measure of the ease with which people can trade cryptocurrencies for each other or fiat currencies. Fiat currencies include American dollars, the euro, and the Japanese yen. One obstacle that the cryptocurrency industry has faced has been the ability of some users to liquidate their holdings for traditional cash currencies.

Final Verdict

Liquidity is the volume of money, assets, or resources an individual or business has available to them that they can quickly and easily turn into cash. Higher liquidity means it's easier for a person or company to keep up with their financial commitments. It's a signal of strong financial health.

If you have more savings than debt, then you are in a state of financial liquidity. That usually translates into higher credit scores you can use to get better terms and conditions and interest rates on your financing. You should also have more spending power and peace of mind.

A company with higher levels of liquidity is in a better position to handle expenses and debts. That makes them better investments for anyone looking to buy shares of healthy businesses. You're more likely to profit from them.

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