What is Liquidity: Meaning, Fund, Risk, Stock market, & Examples
Liquidity is a financial term that refers to the availability of liquid assets to a market or company that can be easily accessed and utilized at their comfort.
What is Liquidity?
How easily an asset can be exchanged, used, and how quickly one can get money out of an asset without any degradation or negative impact on its original value. Investments have strong liquidity when they can be rapidly converted into cash. Cash is the most liquid asset. Stocks and cash are easy to access and trade, which makes them have high liquidity and are prominent. On the other hand, real estate is less liquid as it may take a long time to sell. Liquidity has two areas: liquid market and liquid assets. These are different. In the former, there are always investors in the market who are willing to trade the securities at every price level in the market with high trading activity. In the latter, a liquid asset is an asset that can be easily turned into cash for its total value and with little cost. Money is the most liquid asset because it can quickly and easily be converted into critical assets. In other words, liquidity tells about the degree to which an asset can be quickly bought or sold at a price reflecting its integrity.
Importance of Liquidity:
Liquidity is essential when considering your positions and ability to exit the market. It acts as a provision for cash reserves. It ensures you can swiftly get in and out of the market hassle-free. It plays an essential role in balancing your risk and returns and assists in easing out the complete selling process. However, to sell or convert assets or securities into cash, calls should be liquid, or it would become an issue while selling.
It further accelerates the entire process of transactions. Enterprises must hold enough liquid assets to cover their short-term obligations like bills or payroll, or they might face a liquidity crisis that could further lead to bankruptcy. If the company holds long-term or highly illiquid investments, it might also lead to a less cash situation. This can minimize a company's inability to direct funds to an investment.
Types Of Liquid Assets
Following are some types of liquid assets:
- Cash: Money in coins or notes, as distinct from cheques, money orders, or credit, is called cash. Money that is accessible is a liquid asset and can be used to resolve existing liabilities. It is an instantly used asset. Cash in accounts is also considered liquid as it can be withdrawn for purposes.
- Cash Equivalents: These are interest-earning financial investments. Cash equivalents are highly liquid assets with maturity ranging up to three months, such as treasury bills, drafts, commercial paper, and more. They have substantial credit quality and can be used immediately without any restrictions. They are not identical to cash in hand; however, due to high liquidity and low risk, they are accessible.
- Stocks: There are many buyers in a stock market; therefore, it is considered highly liquid. Stock sales and purchases can be easily made, converting securities into cash whenever required.
- Foreign Exchange: A global over-the-counter market for the trading of currencies entails foreign exchange. Buying, selling, or exchanging cash at a specific rate occurs in this market. It is one of the most liquid assets as it is easily acceptable and convertible in the foreign exchange market without negatively impacting its intrinsic value.
There are two main measures of liquidity: market liquidity and accounting liquidity.
Market liquidity refers to the extent to which a country's stock market or a city's real estate market allows assets to be purchased or sold at specific and transparent prices with ease. The stock market is characterized by higher market liquidity. Market liquidity is a market's feature where an individual or firm can buy or sell an asset quickly and easily without negatively impacting asset price. The market is more liquid when the spread between the bid and ask prices tighten, which grows the market. The liquidity of markets for other resources, such as contracts, currencies, or commodities, generally depends on their size and the open exchanges for them to be traded.
It is a measure of the ease or ability of a borrower to pay their debts as and when they fall due. Accounting liquidity is expressed as a ratio or a percentage of current liabilities to pay short-term obligations.
Some standard measures that can be used to explain accounting liquidity:
- The current ratio divides the current balance from the current liabilities.
- The quick ratio subtracts the inventory from existing assets and divides the result by current liabilities.
- For both ratios, higher results indicate higher liquidity and more excellent financial health.
Considering the liquidity example, the market for air conditioners in exchange for rare books is illiquid and can not exist. However, the bid price is highly liquid in a call offering the sellers enough buyers with close purchasing.
Liquidity is essential for individuals, markets, and even businesses to access the wealth you build. However, they can face some critical points if it does not suit them well and not be converted into cash quickly. To meet liquidity demands, there might be distressed selling of assets. Money is the most liquid of assets, while tangible items are less liquid. There must be enough availability of cash as an asset with an individual or company to meet the obligations in a time of crisis. Tangible assets, such as real estate, are all illiquid compared to the ones mentioned above.