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.

Examples of Liquid Assets

Here are several examples of liquid assets:

  • Foreign currency. Some foreign currency holdings can be readily exchanged into your home currency, depending on the existence of foreign currency exchange controls.

  • Marketable securities. Marketable securities can typically be sold on an exchange within one business day, after which the resulting cash is available for use.

  • Trade receivables. Trade receivables are usually paid for by customers within a few weeks, depending on the payment terms agreed to them. It may be possible to transfer the higher-quality receivables to a factor in exchange for immediate cash.