What Constitutes Liquidity?
Liquidity is the total amount of assets that you can immediately convert to cash, that you or a business has on hand. Your personal liquidity is your cash worth – how much money you have to live off of; a company’s liquidity is how much cash it has on hand to finance the business’s operations. In both cases, if the majority of assets held are illiquid, the net worth might look good on paper, but is not available for immediate financial needs.
Cash is the most obvious liquid asset. Cash is cash: If you have it, you can spend it. Cash assets include physical cash, checking, savings and certain money-market accounts. After these cash-in/cash-out accounts comes savings bonds and CDs. Although you might incur a penalty for cashing these assets prematurely, you can easily convert them to cash. Last in line are market assets -- stocks, options, bonds, commodities. You can sell them to get cash, but it takes a few days for the transaction to clear, if the asset sells at all.
Illiquid assets are those that are not easily converted to cash. Preferred stock shares are not as liquid as common stock because there are limits on how you can sell them. This holds true for restricted stock, as well. Those collectibles you’re considering selling online might also prove to be illiquid if nobody wants them. Art, memorabilia, stamps, coins, anything that is subjective is not necessarily liquid. And perhaps the most illiquid asset of all is real estate, simply because it can take months or even years to sell.
A company with all of its money tied up in its operations, with little money flowing through the door lacks liquid assets. For example, a business might sell a ton of product on credit, so its net sales look solid. If the customers are slow, or fail, to pay for the product, however, the company is losing money, as the amount of physical cash coming in is less than the amount of money to produce the merchandise. The company is stuck with the illiquid asset of credit sales, which must be converted into cash. Comparing current assets vs. current liabilities listed on a company’s balance sheet is an indicator of how liquid a company is. If the company has enough immediate assets to meet all of its liabilities, it is liquid.
The company's balance sheet aside, the actual stock itself also plays a role in the company's liquidity. Liquidity on the stock market basically suggests how quickly a stock will turn to cash based on investor supply and demand. If investors aren’t snatching up a company’s stock, the stock isn’t very liquid because it will be hard to off-load on the market. The stock isn’t liquid if the investor can’t sell it for a profit either. A good gauge is to look at the stock’s activity: If it’s trading daily on a major market, it’s liquid. If it’s sitting in limbo on a secondary market, it’s not liquid.
Tying It Together
You, personally, need cash to be liquid; a company needs cash to be liquid. The more liquid you and any company are, the more cash is on hand to avoid financial distress. If you have a low liquidity rate, this means most of your money is tied up in assets that do not constitute liquidity. If a company has all of its money tied up in operations, it has a low cash flow and is not constituted as liquid -- and perhaps a poor investment choice. Liquidity comes down to immediate cash in personal finance, business finance and investing.