Liquidity refers to how quickly you can turn an asset into cash without affecting its value. Assets that sell rapidly for their full value are considered highly liquid. Assets that take longer to sell or only move quickly at a discount are less liquid (illiquid).
Different asset types often have different levels of liquidity. For instance, cash is more liquid than securities like stocks, which are more liquid than tangible assets like real estate.
However, liquidity can also vary between assets of the same type. Consider the stock market, where large-cap stocks are generally highly liquid thanks to their:
By contrast, penny and OTC stocks are relatively illiquid, as they tend to trade less frequently and have wider bid-ask spreads.
You can look at liquidity in two primary contexts: accounting and market liquidity.
Accounting liquidity measures a company’s ability to pay short-term debts with liquid assets. For example, a company that maintains ample cash or stock investments is more liquid than one that holds real estate.
By contrast, market liquidity measures how easily an asset trades in its public market at stable, transparent prices, such as the stock or real estate markets.
How you measure liquidity varies based on the assets you’re talking about.
For instance, you can measure accounting liquidity using mathematical ratios such as the:
But you can’t measure market liquidity with these same ratios. Instead, you have to consider metrics relevant to the asset in question.
For example, if you’re trading stocks and bonds, you can use bid-ask spreads and daily trading volumes to measure liquidity. And for real estate, you can look at how quickly properties sell in a specific location, as well as how sales prices generally compare to market value.
Generally, investors concern themselves more with market liquidity, as the ability to trade assets quickly can be crucial. Additionally, when you’re saving up for specific goals, it’s wise to know how quickly you can access the cash value of your savings without decreasing their value.
By contrast, accounting liquidity can give you a better sense of a company’s flexibility. As a rule, high liquidity tends to indicate a company on firm financial footing, while low liquidity may suggest that it will struggle during economic downturns. You can also use liquidity ratios to compare companies. (However, you should only compare companies in the same sector, as “normal” varies between industries.)
Understanding the liquidity of your assets is an essential component of risk management. If you can easily convert your accounts into cash, then you’re better positioned to handle emergencies. But if you mainly hold illiquid assets, you may struggle to get the capital you need in a market downturn.
Additionally, you can look at liquidity as another way to diversify your portfolio. Investing in assets of variable liquidity can help you spread your risk, maximize your earnings, and build a stable portfolio over time.
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