Liquidity is the ability of an asset to turn into money in the short term without reducing the price.
The degree of liquidity is the speed with which an asset can be sold or exchanged for another asset . The more liquid an asset is, the faster we can sell it and the less we risk losing when selling it. Cash is the most liquid asset of all, as it is easily exchangeable for other assets at any time.
When it is said that a market is liquid, it means that many transactions are carried out in that market and therefore it will be easy to exchange assets in that market for money.
For a company or a person, liquidity is the ability to meet its obligations in the short term. The most efficient way to calculate a company’s liquidity ratio is to divide current assets (the company’s most liquid resources) by current liabilities (the company’s short-term debts). If the result is greater than one, it means that the entity will be able to meet its debts with the amount of liquid money they have at that time; If the result is less than one, it means that the entity does not have sufficient liquidity to face these debts. The next step for a company is to analyze its solvency, which is its long-term liquidity.
When we speak of market liquidity, we refer to the ability of that market to exchange money for its assets. Stock markets are very liquid markets, the more trading volume there is on a share, the more liquid it is, since the easier and faster we can sell it.
Liquidity is one of the characteristics of financial assets, together with profitability and risk, with which it maintains a close relationship.
One of the most illiquid sectors is real estate. Since selling a house for example, it takes a long time and it is more difficult to find a buyer. If prices were always stable, it would be something more liquid, since if we wanted to sell our house, we could ensure that we can sell at that price almost certainly easily.
Classification of assets according to their liquidity
We can classify financial assets according to their liquidity:
- 1. Money in legal tender: Coins and bills (it is the most liquid there is, since it is already money itself. It can be simply exchanged for other goods).
- 2. Money in banks: Demand deposits, savings and term deposits (see bank deposits).
- 3. Short-term public debt: Treasury bills (see public debt).
- 4. Company promissory notes : Assets issued by private companies (see promissory note).
- 5. Long-term public debt: Treasury bonds and obligations.
- 6. Fixed income: Debt issued by private companies (see fixed income).
- 7. Variable Income: From shares to financial derivatives (see variable income).
Suppose we want to buy a washing machine and its cost is 500 euros. The fastest way to buy it is if we have 500 euros in cash, since in the store the cash will always be accepted. The following would be with the accounts at sight, that is, with a card; In most stores they will accept our card, therefore it is a very liquid asset. If instead, we did not have cash or in the account, but we had some shares in the stock market, we should go to the market, sell them and then go to the store to buy the washing machine.
Therefore, although it is a fairly liquid market, it is less liquid than cash or deposits. If we did not have cash or any other type of financial asset and still wanted to buy the washing machine, we would have to sell an asset (a vehicle for example) and it would take much longer to sell it at a good price and therefore, it is a less liquid asset.