What is Liquidity?

The financial term liquidity refers to the way an asset, security or bond can be converted into available capital without impacting its market price.

Understanding the term Liquidity

Simply put, liquidity refers to the extent with which an asset can be swiftly purchased or sold in the financial markets at a price mirroring its market value. Money is generally referred to as the most liquid asset due to the fact that it can be easily and swiftly transformed into alternative assets. Tangible assets including real estate, collectibles, fine art, are not as liquid as cash. Alternative financial assets, including equities and partnership units, stand at different sectors of the liquidity spectrum.

For instance, let’s say that a consumer wants to buy a oven worth one thousand five hundred dollars, money is the asset that can be most easily used to purchase it. If the consumer in question does not have the money but has a rare stamp collection worth one thousand five hundred dollars, the chances that the individual will find a seller willing and ready to trade the oven for the stamp collection are virtually non-existent. This may not be an issue if the consumer could wait an extended period of time to complete the purchase, however, it could raise an issue if the consumer needed to buy the product in a few days. Rather than selling the stamp collection at its full price the consumer could sell it at a discounted price to get the money faster. Rare stamp collections are an example of an illiquid asset.

Liquidity can be broken down into two key measures

Market Liquidity – describes the extent with which a market, such as a nation’s stock market or real estate market, enables assets to be purchased and sold at stable, clear prices. In the aforementioned example, the markets for ovens in exchange for rare stamp collections is so illiquid that for all intentions it does not exist. Alternatively, the stock market is renowned for high levels of market liquidity. In the event that an exchange has a high quantity of trade that is not controlled by selling, the price a purchaser offers per share (bidding price) and the price the seller is willing to settle for (the ask price) will be considerably close to one another. Investors and traders will not have to relinquish unrealized gains for an abrupt sale. When the spread amongst the ask and bid prices increases, the market becomes less liquid. Real estate markets are commonly more illiquid when compared to stock markets. Market liquidity for alternative assets, including contracts, derivatives, currencies, and commodities, usually depends on their size, and how many active exchanges exist for them to be traded.

Accounting liquidity calculates the ease with which an investor or business can meet their financial obligations with the liquid assets that they have access to. In the example we mentioned above the rare stamps collector’s assets are relatively illiquid and would likely not be worth their full value of one thousand five hundred in a pitch.

Summary of the most important points

The term liquidity refers to the ease with which a security or asset can be exchanged for cash without impacting its market price.

The most liquid asset is cash whereas tangible goods are illiquid and the two key types of liquidity cover market liquidity and accounting liquidity.

Current, fast, and cash ratios are typically used to calculate liquidity.