What is liquidity and why does it matter?
July 26, 2022 7 min read
Trying to understand liquidity can feel overwhelming. But learning about the liquidity of your assets can help you gauge how flexible your money situation is. Learning some liquidity basics could help you make informed decisions about your investments.
This guide covers what liquidity is, how it works and how liquidity might relate to your finances.
- Liquidity refers to how easy it is to turn an asset into cash without losing a lot of value.
- Understanding liquidity can be useful when you’re making investment decisions.
- Liquid and nonliquid assets can serve different purposes: Liquid assets can be used to cover daily expenses and potential emergencies. Nonliquid assets can’t easily be converted to cash but might be ideal for long-term investments.
Liquidity describes how easy it is to convert a financial asset into cash without causing a big loss in value. If you don’t have cash on hand to cover expenses, liquidity can help you convert assets into usable income.
Financial assets can include checking and savings accounts, CDs, bonds, stocks, mutual funds and more.
Why are some assets more liquid than others?
Different assets have different levels of liquidity. That’s because each type takes a different amount of time and effort to convert to cash. And cash, and assets that can quickly be converted to cash, are generally considered the most liquid.
The three main types of assets are cash, securities and fixed. Cash is typically considered the most liquid asset, securities have different levels of liquidity and fixed assets are usually nonliquid.
Real estate wouldn’t be considered a liquid asset, for example. That’s because its value can change over time, and it may take a while to sell.
What types of assets are considered liquid?
Cash and cash-like assets are considered the most liquid. But some types of securities are relatively liquid too. Marketable securities are ones that are easy to sell and convert into cash while holding their value. Common stocks and public bonds are typically the most-liquid types of securities.
Cash and cash equivalents
Cash is considered the most liquid asset because it’s readily available to use. Cash can be paper money, coins, or checking or savings account balances. Cash is very useful for immediate needs and expenses, such as daily spending, rent and building an emergency fund.
The liquidity of securities depends on the type, risk, demand and market price as well as other factors. Money market funds and CDs, for example, are highly liquid. And highly liquid securities are often described as “marketable securities.”
Stocks and bonds are still considered liquid assets, but they are a bit less liquid. This is because you can typically sell a stock or bond pretty quickly, but it may take some time for the cash to appear in your bank account.
What are illiquid assets?
Low-liquidity assets are considered more difficult to buy, sell or convert into usable money. Fixed assets, or illiquid assets, are complex and take a relatively long time to convert to usable cash. And, if you sell an illiquid asset too quickly, you may risk losing some of the asset’s value in the process.
A home is considered an illiquid asset. That’s because real estate has value, but it may take some time to sell property.
Some other examples of illiquid assets include:
- Real estate
- Jewelry and other valuables
- Collections of valuable items
Why is liquidity important?
Understanding the liquidity of your assets may help you know how much money you have available at any given time. If you have too many liquid assets, particularly cash, your money may depreciate over time. And that’s because the amount of cash you have stays the same, while inflation causes the cost of living to rise. So, that dollar may not get you quite as far in 50 years as it does now.
Take liquidity into account when you examine your finances so you can assess your cash flow, plan for the future and prepare for the unexpected.
Types of liquidity
There are a few types of liquidity that are important to consider when you make financial decisions.
Accounting liquidity refers to a borrower’s ability to pay their debts when they’re due. It refers to a ratio that shows current liabilities, or debts owed, and a person’s ability to pay them over the course of a year.
Market liquidity refers to how easy it is to buy and sell particular securities in financial markets. Market liquidity is the degree to which you can quickly buy or sell an asset at a stable price, often on a stock exchange.
If market liquidity is high for a particular stock, that means it’s usually easy to buy or sell it without causing a large change in price. If market liquidity is low, the opposite can be true: Buying and selling can have a significant impact on the asset’s price.
How to measure business liquidity
Businesses use different ratios to calculate liquidity. There are several ratios a company may use to measure different aspects of liquidity.
- Cash ratio: This ratio shows your ability to repay short-term debt with cash or cash-like resources, including liquid securities.
- Current ratio: This ratio measures your ability to pay short-term obligations, typically those due within one year.
- Acid-test ratio (quick ratio): The acid-test ratio measures the ability to pay current outstanding debts when they come due and applies to only the most-liquid assets.
Having a mix of assets can help you prepare for your financial future and cover your immediate expenses. And understanding how liquidity works in the stock market can help you make sound investment decisions.
Liquidity can be a key consideration for managing your cash flow and diversifying your assets. As you learn more about liquidity, check out these money management tips.