What is Liquidity?

Liquidity explains how easily an asset or shares can be bought or sold on the market at a price that represents its intrinsic value. In other words, liquidity means the ease with which you can convert a financial instrument to cash.

Cash is, globally, considered the most liquid asset, whereas tangible assets are all relatively illiquid, such as real estate, fine art, and collectables. Many financial assets fall on the liquidity continuum at different places, ranging from equities to partnership units.

Break Down of Liquidity

Cash is considered to be the liquidity norm because it can be converted to other assets as quickly and easily as possible. If a person wants a refrigerator worth Rs 15,000, cash is the commodity that can be most efficiently used to get it. If that person has a rare collection of books that are priced at Rs 15,000 but no cash, she is unlikely to find anyone willing to trade them for a fridge.

Alternately, she will have to sell the set, and use the cash to buy the refrigerator. That may be ok if the person can wait for months or years to make the purchase, but if the person only had a few days, it could present a problem. She/he may have to sell the books at a discount, rather than waiting for a buyer willing to pay the full amount. Rare books are a case in point of an illiquid asset.

Market Liquidity

Market liquidity refers to the degree to which a market, such as the stock market of a nation or the real estate market of a region, permits the buying and selling of assets at stable, clear rates.

Accounting Liquidity

Accounting liquidity tests the ease with which an individual or company can meet its financial obligations with the liquid assets that are available to them—the ability to pay off debts when due. In the above case, the assets of the rare book collector are fairly illiquid and would probably not be worth their full Rs 15,000 worth in a pinch.