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    What is Liquidity? Understanding the Role of Liquidity in Financial Planning

    Oct 31, 2022
    4 min | Views 2534

    We often come across the term ‘liquidity’ in finance and investment. But what does liquidity mean? Read this post to find out.

    Becoming a savvy investor or someone with laser-sharp money management skills requires an individual to master the basics of finance. Among the various terms that deserve your attention, one of the most important is liquidity. You might have already come across the word several times without probably understanding it.

    So, what is liquidity? Why is it important in finance? Here’s everything you should know-

    What is Liquidity?

    Liquidity of a financial instrument or an asset represents the ease with which one can convert it into cash without impacting its price negatively. Cash is considered the most liquid asset as one can easily convert it into other assets.

    So, what are liquid assets? Liquidity varies between assets and investments. For instance, most open-ended mutual fund investments are generally considered liquid, as investors can redeem their units as required. Moreover, investors can withdraw the redemption amount directly to their linked bank accounts.

    But the same cannot be said for real estate, as selling a property is generally a time and effort-consuming process that also involves plenty of paperwork. So, open-ended mutual funds are more liquid than real estate.

    Why is Liquidity Important?

    Without liquidity, it can be challenging to sell an asset. If you cannot sell the asset, you cannot convert it into cash.

    For instance, let's assume you want to sell a painting that has been in your family for more than a century for Rs. 10 lakhs. But if there are no buyers for the painting, the price is irrelevant as nobody is willing to pay the price you're quoting. So, you might have to reduce the cost or hire an auction house to sell the painting.

    But if it was something like stocks which is generally highly liquid, you might have been able to sell it quickly at its market price.

    Click here to check - When to Sell Mutual Funds?

    Liquidity Example

    When it comes to investments, stocks or equities are known to be highly liquid. However, not every stock has the same liquidity level. Some of them are more liquid as they attract more investors and traders, while some are not as liquid and are not traded as actively. Daily volume is an excellent liquidity indicator for stocks.

    For instance, let’s say on a trading day, the stocks of ABC company had a trading volume of 2 million on the stock exchange. While the stock had good liquidity, it was still lower than XYZ company, which had a trading volume of 9 million shares on that day. So, while ABC and XYZ had excellent liquidity, XYZ was more liquid than ABC.

    What are the Different Types of Liquidity?

    Liquidity can either be market liquidity or accounting liquidity. Here’s what they mean-

    • Market Liquidity

      Market liquidity meaning is the extent to which any market allows buying and selling of assets at transparent and stable prices. In simple words, it refers to the number of buyers and sellers available in the market and how easily the buy and sell transactions can take place.

      For instance, the stock market is generally associated with having higher market liquidity due to higher trading volume. In comparison, the real estate market has lower market liquidity as the number of buyers and sellers is significantly lower.

    • Accounting Liquidity

      Accounting liquidity is the ease with which an individual or a company can meet debts and financial obligations by liquidating their asset. It is assessed by comparing the available liquid assets against the current financial year's total outstanding debts and obligations.

      Accounting liquidity is generally measured through the cash ratio or current ratio. The cash ratio method measures cash flow for meeting financial obligations. On the other hand, the current ratio measures the available assets you can liquidate to meet the financial obligations of the current year.

    Liquidity and Investments

    Understanding liquidity definition and how it works is essential to become a successful investor and managing your finances more efficiently. Apart from individuals, liquidity is also vital for businesses, as a liquidity crunch can make it challenging to meet their financial obligations.

    If you’re about to begin your investment journey, try to learn more about liquidity and prefer investing in liquid assets to ensure the investment can be easily converted into cash when required.

    Mutual Fund investments are subject to market risks, read all scheme related documents carefully.

     

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