What is liquidity?
Liquidity refers to the efficiency or ease with which an asset or security can be converted into cash without affecting the market price. In other words, liquidity is how quickly an asset can be bought or sold at its real price. It requires a market to sell and buy. In other words, it requires supply and demand. The more in demand a product is, the faster it can usually be sold. For example, if you have a very valuable heirloom at home that you would like to sell, you need a potential buyer. If there are many interested parties, you can sell the heirloom very quickly at the real price. For example, if you have a very rare stamp collection, it would be easier to sell than a stamp collection with less rare stamps. You may have to sell your heirloom for a lower price to find a buyer with the right willingness to pay, as your heirloom is illiquid.
The most liquid asset of all is cash itself, while tangible assets, such as real estate, are relatively illiquid. The two main types of liquidity are market liquidity and accounting liquidity.
Market Liquidity and Accounting Liquidity
Market liquidity describes the extent to which a market enables the sale and purchase of assets at transparent prices. The stock market, for example, is considered to be relatively liquid. Exchange-traded shares are one of the most liquid investments, but there are differences here too. Not all shares are equally liquid. For some shares there is a larger market, so they are also traded more actively on the stock exchanges. This means that the demand for these shares is greater. Liquid shares can usually be recognized by a large daily trading volume. Normally, the price that the buyer is prepared to pay (bid price) is relatively close to the price that a seller is demanding (ask price). This leads to a market equilibrium and ultimately to the conclusion of the transaction. If markets are relatively illiquid, it is possible that sellers will have to sell their assets at a discount in order to conclude the transaction more quickly, as the search for a suitable buyer with a suitable willingness to pay may take too long.
Accounting liquidity, on the other hand, measures a company’s ability to pay short-term debts as they fall due with the available current assets. Accounting liquidity is therefore one of many indicators that provide information about the financial health of a company. See also the detailed article on liquidity ratio 1, 2 and 3.