Liquidity definition

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What is Liquidity?

Liquidity is the ability of an entity to pay its liabilities in a timely manner, as they come due for payment under their original payment terms. Having a large amount of cash and current assets on hand is considered evidence of a high level of liquidity.

When applied to an individual asset, liquidity refers to the ability to convert the asset into cash on short notice and at a minimal discount. Having an active market with many buyers and sellers typically results in a high level of liquidity. When an asset can only be sold off in short order at a steep discount, it is not considered to be very liquid. Thus, an account receivable is usually considered to be quite liquid, since it can be collected from a customer within a short period of time, while a fixed asset is not considered to be very liquid at all.

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Why is Liquidity Important?

Liquidity is an essential issue for managers, because a business must always have sufficient cash available to pay for its obligations as they become due for payment. Otherwise, the business may need to seek bankruptcy protection. Consequently, the single most important issue for most treasurers and chief financial officers is whether the current assets of a business are properly aligned with its current liabilities. If not, they need to obtain alternative financing, such as a line of credit, to ensure that there is always enough cash in reserve to pay for obligations.

Ranking of Market Liquidity

Here is a top-down ranking of market liquidity for ten types of assets, from most liquid to least liquid. Liquidity refers to how quickly and easily an asset can be converted into cash without significantly affecting its price.

  1. Cash. Cash is the most liquid asset because it is already in its final form and requires no conversion. It’s immediately available for transactions.

  2. Publicly traded stocks (large-cap). Large-cap stocks traded on major exchanges (like Apple or Microsoft) are highly liquid due to high trading volume and a large number of buyers and sellers.

  3. Government bonds. U.S. Treasuries are highly liquid and considered virtually risk-free, with active markets and low transaction costs.

  4. Exchange-traded funds (ETFs). ETFs are liquid investment funds traded like stocks on exchanges, allowing easy entry and exit at market prices throughout the trading day.

  5. Corporate bonds (investment grade). While less liquid than stocks or Treasuries, investment-grade corporate bonds have relatively active markets, especially for larger, well-known issuers.

  6. Mutual funds. Mutual fund shares are not traded throughout the day and must be redeemed at the end-of-day NAV, which limits intraday liquidity.

  7. Real estate investment trusts (REITs – publicly traded). Publicly traded REITs offer decent liquidity since they are exchange-listed, but they can still be affected by market volatility and less frequent trading than typical stocks.

  8. Real estate (direct ownership). Physical real estate is highly illiquid due to long transaction times, high costs, and the need for buyers and legal processing.

  9. Private equity. Investments in private companies are illiquid since there’s no public market, and it may take years to realize a return through an exit like an IPO or acquisition.

  10. Collectibles (e.g., art, antiques). Collectibles are among the least liquid assets, as finding a buyer at a fair price can take significant time and depends on subjective valuation.