Liquidity is a measure of how easily an asset can be converted into cash. Assets can be highly liquid, such as stocks, which can easily be sold for cash on the open market. Some assets are considered non-liquid, such as real estate or rare collectible items with few potential buyers.
If you’re interested in investing, it’s important to understand how liquidity works and how it can affect your investing strategy. Below, we’ve explained what liquidity is and how it can affect an investment. We’ve also provided examples of the most liquid and least liquid asset types.
What is Liquidity?
Liquidity is how easy it is to convert an asset into cash. If you can sell an asset for cash easily, it’s considered to be highly liquid. If you might need several months or years to sell an asset, it has a relatively low degree of liquidity.
If you’d like to be able to quickly convert your investment assets into cash, you’ll want to focus on investing in assets that have a high degree of liquidity.
On the other hand, if you’re interested in investing for the long term and don’t mind potentially waiting several months or years to realise gains from an investment, an asset’s liquidity might be less important for you.
Examples of Liquid and Non-Liquid Assets
An asset is liquid if you can easily convert it into cash without significantly impacting the amount you receive for the asset upon sale.
The most liquid asset of all is cash. Banknotes, bank account balances and other forms of cash are extremely liquid. You can immediately use cash to buy any product or service without having to convert it into another type of asset.
Other liquid assets include things like unrestricted shares and government bonds. Both of these asset types can easily be sold for cash without affecting the price of an asset.
Some shares are less liquid than others. For example, if you own restricted shares in a certain company, there might be limitations on how soon you can sell the shares and the total quantity of shares you can sell.
In certain cases, shares and other assets that are normally highly liquid can become less liquid due to their impact on marketing pricing. For example, if you own a large amount of shares in a company with a small market cap, selling them may affect the market value of the shares.
Assets that require longer to sell are non-liquid. For example, real estate, industrial equipment, vehicles and other large assets that have a limited market of potential buyers typically take far longer to sell than shares, bonds and other highly liquid assets.
This is also true for assets like collectibles and art. These assets have a small market of buyers, meaning they can often take months or years to sell at full value.
Why Liquidity Matters
Liquidity is important because it affects how easily you can convert gains from an investment into cash.
For example, if you need to access cash relatively quickly, an investment such as shares in a specific company or government bond is very convenient. Assets of this type are fast and easy to convert into cash, allowing you to realise your capital gains and access your money.
Assets like real estate, on the other hand, can take months or years to convert into cash. This means that your cash flow can be affected even if your investment has generated a significant amount of capital appreciation.
If you own a non-liquid asset and need to access cash, it’s important to remember that selling the asset isn’t the only option. It’s usually possible to borrow against the value of a non-liquid asset such as a residential property, allowing you access cash without selling the asset.
Liquidity and Running a Business
Liquidity isn’t just important for investors. It’s also an important concept for businesses. When a company is liquid, it’s able to meet its current liabilities. For example, a company with significant profits and strong, consistent cash flow that can easily pay its bills has financially liquidity.
Even a company makes large profits, it can have difficulty trading if it doesn’t have a significant amount of liquid assets. For example, a company can make a profit but have limited cash flow, affecting its ability to operate and pay its creditors.
This can potentially lead to a liquidity crisis, in which a company doesn’t have enough cash flow to pay its current liabilities.
As an investor, it’s important to understand liquidity. Not all assets are equally liquid, meaning that if you need to be able to convert your investments into cash easily, you’ll want to prioritise assets that have a high degree of liquidity.
Liquidity is also important for entrepreneurs. If you run a business, it’s important to make sure that your company has enough liquid assets to comfortably pay its current liabilities and avoid the risk of a liquidity crisis.