In business, economics or investment, market liquidity is a market's feature whereby an individual or firm can quickly purchase or sell an asset without causing a drastic change in the asset's price. Liquidity is about how big the trade-off is between the speed of the sale and the price it can be sold for. In a liquid market, the trade-off is mild: selling quickly will not reduce the price much. In a relatively illiquid market, selling it quickly will require cutting its price by some amount. Liquidity can be measured either based on trade volume relative to shares outstanding or based on the bid-ask spread or transactions costs of trading.
The term liquidity is used to describe the ease with which an asset/item can be converted into money (cash) with little or no affect on the actual asset price. On the other hand, illiquid assets are harder to convert. However, when converted, they may have a significant/substantial reduction in price (or value). Primarily, money is the most liquid of all types of assets while collectibles, fine art and real estate are relatively illiquid. An illiquid asset can be extremely difficult to sell, such as a property, and there may be a significant difference between the actual value of the said property for sale and the price at which it is sold.
Simply put, money is the standard of liquidity because as compared to real estate, it is can be easily and quickly converted when needed, into other types of assets. Let’s take a look at an example to understand this phenomenon better:
Here, let us suppose you want to by a $2000 TV. With cash in hand, you can easily purchase what you want. However, if you don't have cash, but a fridge that is worth $2000, then you're unlikely to find a seller who is willing to take your refrigerator worth $2000 and trade it with their $2000 TV. In such as scenario, you have to put your fridge for sale first and wait for weeks and sometimes even months to sell it off. Besides this, selling your fridge, which is originally worth $2000, doesn't mean that you will get the same price (its full value) back. In fact, to close a deal fast, you might have to sell your fridge at a discount, making you add more money to the sale amount in order to buy the TV.
Why is Liquidity Important?
Here are some of the many reasons why financial liquidity is important for investors:
- Liquid assets can be easily reinvested
- With liquid assets, investors can quickly react to the market moves and realize big investment gains while lowering risk
- Besides this, liquidity also helps investors support their changing lifestyle needs as it provides them the freedom to convert assets into cash whenever required
On the other hand, accounting liquidity is described as the measure of the entity's ability to pay off its debts. It refers to comparing the entity's liquid assets to its current liabilities that must be paid in one year. Different types of liquidity management ratios are used to identify/determine the entity's accounting liquidity such as current ratio, quick ratio and cash ratio.