Liquidity means how easily you can turn something into cash without changing its price. Cash is the most liquid asset. So, having enough cash influences how smoothly markets work.
The easier it is to turn something into cash, the more liquid it is. It’s quick and cheap. Assets that aren’t as liquid take more time and might cost more to convert into cash.
Understanding Liquidity
In simpler terms, liquidity shows how quickly you can buy or sell something in the market at a fair price. Cash is the easiest asset to turn into other things because it’s so flexible. But things like real estate or rare books are harder to sell quickly.
For instance, if someone needs $1,000 for a refrigerator, they can use cash. But if they only have a rare book collection worth $1,000, it’s tough to find someone who’ll trade a fridge for books. They’d have to sell the books first, which might take a while. If they’re in a hurry, they might have to sell the books for less than they’re worth. This shows why rare books are considered hard to turn into cash quickly.
Market Liquidity
Market liquidity means how easy it is to buy and sell things in a market at prices that stay steady and clear. For example, it’s almost impossible to find a market where people trade refrigerators for rare books because it’s so hard to do.
But in the stock market, it’s easier. When there’s a lot of trading going on and it’s not all about selling, the price a buyer offers for a share (called the bid price) and the price a seller wants to get (called the ask price) is usually pretty close.
This closeness means investors don’t have to lose out on potential profits just to sell quickly. When the difference between bid and ask prices is small, the market is liquid. When it’s big, the market is not liquid. Real estate markets are usually not as easy to trade in as stock markets. The ease of trading other things like derivatives, contracts, currencies, or commodities depends on how big they are and how many places you can trade them.
Accounting Liquidity
Accounting liquidity shows how easily a person or a company can handle their financial responsibilities using the cash and assets they have—like paying off debts on time.
For instance, in the previous example, the rare book collector’s assets aren’t very easy to turn into cash quickly. If they needed money urgently, they might not get the full $1,000 value for their books. In investing, checking accounting liquidity means comparing how much cash and easily sold assets you have to the debts you owe in the next year.
There are different ways to measure accounting liquidity, with some being stricter about what counts as a “liquid” asset. Analysts and investors use these ratios to find companies with strong financial positions. It’s also a way to see how secure a company’s finances are.
Why Is Liquidity Important?
When markets lack liquidity, it gets hard to sell or turn assets like securities into cash. Let’s say you own a rare family heirloom valued at $150,000. But if there are no buyers for it, its value doesn’t matter much because nobody will pay close to that amount—it’s very hard to sell, or in other words, very illiquid. You might even need to hire an auction house to help find potential buyers, which takes time and money.
On the other hand, liquid assets can be sold quickly and easily for their full value, with low costs. Companies need enough liquid assets to cover short-term bills or payroll. If they don’t, they might face a liquidity crisis, which could lead to bankruptcy.