Looking through financial content, you will see the terms ‘liquidity’ and ‘liquid assets’ popping up a lot. Whether it is about a company’s liquidity or liquid assets in an individual investment portfolio, liquidity seems to be a big deal in the world of business and investment. Specifically, having or not having liquidity can make or break an enterprise or portfolio.
As such, anyone interested in the worlds of business and money should get acquainted with these terms and how they can affect people and businesses. The following guide will help understand what exactly these terms mean and why they are important in the first place.
What Is Liquidity?
In financial terms, liquidity is about how easily ‘liquid’ cash can be obtained. When talking about a business, for example, liquidity refers to how easily the entity can convert its current assets into spendable currency. A company’s liquidity level also indicates how much liquid cash it has at its disposal.
For example, let’s say that a business needs to pay off a debt or pay its employees. The business might have $1 million in assets like furniture or stocked goods but only $10,000 in actual cash in the bank. In that case, a business has low liquidity. But if the stocked goods are the type that can easily be sold to raise money, you would say that the business is in a good place liquidity-wise. This is also not just limited to assets that can be converted to cash but also how easily the business can acquire a line of credit or a loan.
The same principle applies to individuals. An individual might have a million dollars in property, for example, but not be able to quickly sell off this property to raise cash, in which case they are in a bad liquidity situation. To sum up, liquidity is an important indicator but not the ultimate authority of a person or company’s financial state. A person/business might have very valuable assets but not just the type that can be sold off quickly and easily.
Understanding liquidity equips us to better understand liquid assets and how they work. A liquid asset refers to cash or any asset that can be easily converted to cash when needed. The ultimate goal of liquidity is to have enough cash on hand to meet any immediate need and liquid assets are those that help to push this goal forward.
There are many types of assets in the world but what separates liquid from non-liquid assets is how easily they can be turned into cash. Both stock and real estate are assets but while one can be sold at a moment’s notice, the other will take weeks at a minimum to be sold for cash.
Some examples of liquid assets include:
- Cash. This refers to physical cash that is kept on hand and can be spent at any time.
- Bank accounts. This refers to cash that is kept in easily accessible bank accounts such as checking or savings accounts and can be easily withdrawn. Fixed deposit accounts are not considered liquid assets.
- Marketable securities. These are stocks, bonds, and shares that are listed on public exchanges and can be sold at any time.
- Money market funds. These include assets like government securities and commercial papers that can easily be sold.
- Mutual funds. These are professionally managed funds that put together resources from multiple investors and can be sold in under a day.
- Treasury bills. These can be redeemed for cash at the end of their cycles, which range from days to weeks.
- Cryptocurrency. These are digital tokens that can be bought and sold quite easily.
Liquid Assets vs Non-Liquid Assets
Liquid assets have been touched, but it is also important to explore non-liquid assets. As the name would suggest, non-liquid assets are those that cannot be easily converted into spendable cash. This is not to say that these assets can not be sold at all. Instead, this means that the assets will take so long to sell and usually have so many steps or hurdles involved that their cash value cannot be obtained fast enough to meet immediate needs.
Some examples of non-liquid assets include real estate, collectibles like valuable art and priceless jewels, vehicles and other machinery, and retirement or fixed deposit accounts. Take a moment to consider what it would take to turn any of these into cash. It is very rare that a house or a valuable painting is sold in only a few minutes. Instead, inspections need to be carried out, a buyer needs to be found (and fewer people are buying such items), and contracts need to be signed.
When comparing and contrasting liquid and non-liquid assets, a few key differences need to be kept in mind. For starters, liquid assets tend to be those with a wider buying market compared to non-liquid ones. Also, liquid assets tend to lose less value when they are sold compared to non-liquid ones.
Again, neither asset class is necessarily superior to the other and both have their pros and cons.
One thing to note about liquidity is that it is not an abstract concept that can’t be defined but instead, it is measurable and quantifiable. In the world of business, there are three main ratios that are used to measure liquidity: current, quick, and cash ratios. These are calculated using the following formulas:
- Current Ratio = Current Assets / Current Liabilities.
Ideally, a business is considered healthy if it has a current ratio of 2:1.
- Quick Ratio = (Cash + Accounts Receivable) / Current Liabilities.
A good quick ratio is considered anything above 1:1.
- Cash Ratio = (Cash + Marketable Securities) / Current Liabilities.
A good cash ratio is anything above 1, as it indicates that there is sufficient cash to cover business expenses.
Why Asset Liquidity Matters
The simplest reason why liquidity is important is that businesses and people have a lot of responsibilities that might crop up and that need to be addressed immediately. If a piece of business equipment breaks down, a debt arises, salaries need to be paid, or a personal crisis comes up, being able to immediately pay for them is key to a business or person staying afloat.
But these responsibilities can only be taken care of if there is cash on hand at short notice. And if there isn’t cash on hand, there have to be assets that can be used to raise funds quickly and easily. This is why a business or person having asset liquidity is such a big deal. A business that has no liquid assets is one that will not likely be able to meet responsibility and this can lead to long-term problems. For example, not paying staff on time or defaulting on loans due to liquidity could bankrupt a business over time and lead to more issues. The same can be said of any individual who does not have liquid assets.
As such, asset liquidity is important for a healthy financial life.
There are several things that are indicative of a business’s chances of success or an investor’s chances of making a healthy return on their investment and one of these is liquidity. Having liquid assets at your disposal means that you can raise cash whenever the need arises and take care of any financial responsibilities that come up.
Liquid assets include things like bank accounts, stocks, mutual funds, and cryptocurrencies that you can sell easily and it will not take a lot of time. And while it is not the only factor that contributes to success, liquidity is an important one to keep in mind.